How to use a Roth IRA to save money for college
The cost of a college education continues to soar with no end in sight. College tuition rises at more than twice the rate of inflation, growing by about 8% per year, on average. At this rate, the cost of a college education will double every nine years.
This has many parents understandably concerned about paying for their children’s higher education — especially parents of young children who might be a decade or more away from starting college. The good news is that there are a variety of different savings vehicles available to help you save money to pay for college down the road.
529 Plans: Pros and Cons
Section 529 plans are one of the most popular college savings vehicles. These accounts allow you to save money on a tax-deferred basis while investing funds in market instruments to potentially grow your savings. Also, there are no annual limits on contributions to 529 plans and no income limits for opening a plan.
But there’s one potential drawback to 529 plans: The money you save must be used for qualified education expenses. If your child decides not to attend college or receives scholarships or other financial aid and doesn’t need the savings to pay for college, the funds will be subject to taxes and a 10% penalty when withdrawn.
This is why some families are taking a different approach by using a Roth IRA to save money for college. Roth IRAs are usually thought of as a retirement savings tool, but their flexibility makes them an option for killing two birds — saving for both retirement and college — with one stone.
Roth IRA Nuts and Bolts
With traditional IRAs, funds generally cannot be withdrawn before age 59½ without incurring taxation and a 10% early withdrawal penalty. But Roth IRAs are different. Contributions to Roth IRAs are made on an after-tax basis — in other words, the money has already been taxed. So no tax or penalty is assessed when these contributions are withdrawn, regardless of how old you are.
Note that while contributions (or principal) and converted and rolled over funds can be withdrawn from a Roth IRA at any age tax- and penalty-free, the same isn’t true for Roth IRA earnings. If you withdraw Roth IRA funds before age 59½, any money that your investments have earned will be subject to tax at your current ordinary income tax rate and the 10% penalty. (There are exceptions for disability, death and the purchase of a first home.)
Also, five calendar years must have elapsed since you opened the Roth IRA and made your first contribution in order to avoid taxes and penalties on earnings withdrawals.
What About Retirement?
Using a Roth IRA to pay for college expenses raises an important question: Could this strategy jeopardize your retirement financial security? After all, the primary purpose of an IRA for most people is to help ensure a financially comfortable retirement.
The answer to this question will depend on such factors as whether or not you have other potential sources of retirement income and how much of your Roth IRA you withdraw to help pay for college.
One strategy utilized by some families is to use a portion of their Roth IRA principal for college expenses and leave the earnings in the account for retirement.
Another strategy is to use a Roth IRA as a supplemental savings tool to a 529 plan. For example, you could contribute half of your allotted college savings to a 529 plan and half to a Roth IRA. This would help you achieve greater diversification with your college savings by spreading the money out among a wider variety of investment instruments.
For example, utilizing a self-directed Roth IRA to invest in income-producing properties through either private equity, private debt, or crowdfunding investment opportunities enables investors to diversify their portfolios beyond typical private, non-exchange traded investments.
Can You Open a Roth IRA?
It’s important to note that there are income restrictions for opening a Roth IRA. In 2021, your modified adjusted gross income (MAGI) must be $140,000 or less if you’re single or $208,00 or less if you’re married and file jointly in order to open and contribute to a Roth IRA.
If you qualify for a Roth IRA, you can contribute up to $6,000 annually to the account in 2021, or $7,000 if you’re 50 years of age or over. This assumes that your MAGI is less than $125,000 (if you’re single) or $190,000 (if you’re married). If your MAGI is between $125,000 and $140,000 (if you’re single) or $198,000 and $208,000 (if you’re married), you can make a reduced annual contribution.
Please contact your financial advisor if you have more questions about using a Roth IRA or a self-directed Roth IRA as a college savings tool.