Today’s post is written by a fellow fee-only advisor, Greg Phelps, CFP®, CLU®, AIF®, AAMS®, of Redrock Wealth Management.
Saving for a child’s college education is perhaps one of the most noble things a parent will ever do. It’s also one of the toughest financial goals to tackle, because similar to healthcare costs, college expenses have risen across the board at 5% per year.
The sacrifice we make for our kids can really hit the pocketbook, not that we’d change it however!
If you don’t know where to start, you’d probably initially think of a 529 account for college savings. While 529 plans are great, the Roth IRA is an often overlooked alternative to the 529 plan. In some cases, a Roth IRA can be a valuable addition to a family’s college savings plan, especially given the recent change to prior-prior year income reporting.
What does a 529 plan provide for college savings?
529 plan contributions are NOT tax deductible. You make them with after-tax savings dollars instead.
The 529 plan accounts do provide tax deferred investment growth however. That is to say, the account grows tax-free throughout the years, and when you withdraw funds for QHEE’s (Qualified Higher Education Expenses), the withdrawals are also tax-free.
Distributions of your principal investment can always be taken tax free no matter when or why you withdraw the funds. It’s only the investment growth that may be subject to taxes and penalties.
The important part is what constitutes Qualified Higher Education Expenses. Let’s start by reviewing some NON-qualified expenses:
- Medical expenses (including student health fees)
- Similar personal, living or family expenses
Remember, NON-qualified expenses withdrawn from a 529 plan may incur normal income tax AND a 10% penalty. For this reason it’s smart to do some solid college planning before overfunding a 529 plan account.
Now let’s go over some covered QHEE’s. The first rule is the expenses must be required by the school to qualify. Here are some examples:
- Tuition and fees
- On-campus room and board expenses (the student must be enrolled at least half time)
- Off-campus room and board expenses (must be at least a half-time student, and only allowed up to the school published room and board allowance).
- Required books and supplies
- Computers, software, and related expenses for college (thanks to the Path Act of 2015)
- Special needs equipment for students with disabilities
So the 529 plan is a great way to save and invest for college expenses. However, if you over fund it you may end up paying tax and a 10% penalty on the distribution.
Why a Roth IRA may fit in your college savings plan
Similar to the 529 plan, a Roth IRA is a savings and investment vehicle which provides some great tax advantages. Your contributions are non-deductible, but growth is tax deferred until withdrawn. If funds are withdrawn correctly (after at least 5 years and you’ve reached the age of 59 and 1/2), the distributions are always completely tax free.
So why would you want to use a Roth IRA to save for college? It seems like the two were created for completely different purposes.
It’s true, the two types of accounts are mutually exclusive and very different. The 529 plan was created solely for college planning. The Roth IRA was created for general retirement spending.
The beauty of the Roth IRA however, is you can always withdraw your principal contribution amounts tax free at any time. The IRS considers Roth distributions to be done on a principal first basis. This means your investment growth may be left alone to keep growing tax free until you do reach the 5 years and 59 and 1/2 minimum for tax free withdrawals.
As a side note, non-qualified 529 plan distributions are considered taken on a pro-rata basis. That means a portion of it is considered taxable, and a portion is considered return of principal.
How the FAFSA treats 529 plans and Roth IRAs
To understand if a Roth IRA is a fit for your family’s college savings plan, you need to understand how the FAFSA treats 529s and Roths.
529s are reported on the FAFSA as parental assets. All of the family’s 529 accounts—for each student—are reported as parent assets. So a family with two college-bound students who each had $30,000 in a 529 account would report $60,000 in assets from those 529 accounts, regardless of whether they are filing the FAFSA for one or both students. Assuming the family had other assets in excess of the asset protection allowance, these 529 accounts would increase their EFC by $3,384.
Roth IRAs, on the other hand, are not reported as assets on the FAFSA because they’re retirement accounts. So if that $60,000 were in a Roth, it doesn’t even have to be listed on the FAFSA.
Advantage: Roth IRA
It’s different when the money actually gets spent. 529 funds get some special privileges in the FAFSA: When the funds are withdrawn, they do not have to be reported as income, even though there is (likely) growth in the account. (This is different from a traditional taxable account where any gain is reported as income, both to the IRS and to the FAFSA.) But here the Roth IRA has drawback: Under “Parents’ Untaxed Income” you are required to report nontaxable IRA distributions, which are then added to income. So while the 529 distribution would add nothing to your EFC, taking $10,000 out of a Roth IRA to pay for college would increase your EFC by $4,700.
But thanks to the recent change to prior-prior year income reporting, Roth IRAs are starting to make sense again as a piece of your college savings strategy. That’s because distributions taken after the last FAFSA income year don’t get reported. What does prior-prior mean? It means two year old income data. For example, the FAFSA for the 2017-2018 school year uses 2015’s income data. That means that the income tax year that starts January of sophomore year won’t be used for that student’s FAFSA, so a Roth IRA can be used for the later college years without reporting the distribution.
Advantage: Roth IRA
And when it comes to education tax credits, you can’t take a tax credit for QHEE’s paid for with 529 funds. But you can if you used Roth IRA funds.
Advantage: Roth IRA
So the Roth IRA is super cool, but how would you use it for college savings?
It works like this. Starting when your child is born, you max out your Roth IRA for 18 years (until they enter college). If you earn 7% per year, it looks like this:
You’ve saved and invested about $458 per month for 18 years. Your investments have earned $101,084. Your Roth IRA is worth $200,084.
If you withdrew the entire plan before turning age 59 and 1/2, the $101,084 in investment growth would be fully taxable AND incur a 10% penalty. You could easily lose a third of it to the IRS.
The $99,000 in principal contribution however is never taxed. It’s a return of principal investment essentially, money which has already been taxed.
So little Johnny is ready to go to college, and you need some money to pay for it. You can withdraw up to $99,000 from your Roth IRA with no taxes or penalties.
Actually, this distribution can be used for any purpose you deem worthy! In this case, it’s little Johnny’s college expenses.
The beauty of using the $99,000 from your Roth IRA, is you’re leaving $101,084 to continue growing for your retirement TAX FREE! This is literally the epitome of killing two birds with one stone.
Using a Roth IRA to fund college expenses in summary
The Roth IRA for college savings present an amazing opportunity, especially in light of last year’s changes in the FAFSA.
There are two downsides to using the Roth IRA for college savings however. The first downside is your contribution amounts are limited. You can only contribute a maximum of $5,500 per year ($6,500 if you’re age 50 or older). This amount will however be indexed upward for inflation over time. The second, as discussed above, is that distributions from a Roth IRA need to be reported on the FAFSA as income, meaning that for aid-eligible families, the Roth can’t be used for college funding until the later years. Families with multiple students a couple of years apart will have limited years in which to use the Roth IRA money or may need to borrow during the school years and use the Roth distributions to pay off the loans after college.
The 529 plan on the other hand, has no maximum contribution. You can put as much as you want into a 529 plan, however keep in mind the gift tax rules for amounts over $14,000 per person/per donor.
Give some serious consideration to adding a Roth IRA to your college savings mix. The flexibility and extra benefits it may provide for your retirement in addition to college savings, are well worth mixing it into your financial plan.
About the author
Greg Phelps, CFP®, CLU®, AIF®, AAMS® is a CEFEX certified fee only fiduciary financial advisor in Las Vegas. His firm – Redrock Wealth Management – was founded in 2005 to provide exceptional retirement planning services to clients both in Las Vegas and nationally.
There are 2 comments
Great article, but you missed one important limitation on Roth.
Not everyone can contribute to a Roth IRA due to income being too high or not even having wage income. (I can’t make a free Roth conversion due to existing Rollover traditional IRAs)
As far as I know, anyone can fund a 529 plan, regardless of income level or origin. Advantage: 529
Yes, you are correct: anyone can fund a 529 plan, and the cap on how much you can contribute is quite high. In addition, I’m not aware of any state that offers a tax deduction for contributions that has an income limit for those contributions. 529s are excellent savings vehicles with tons of advantages. The change to prior-prior year income reporting has some nuances that give Roths (for those who are eligible) some new advantages in the formulas.