By Len Nowak, CFP®, AWMA®, CTS™
When Congress enacted the Taxpayer Relief Act of 1997, which included establishing the Roth IRA, they probably weren’t thinking about college planning. The Roth IRA was introduced with retirement in mind, but due to some unique features it can actually be a very good college planning and savings tool as well.
There are many ways to save for college for your children, each with pros and cons. The 529 college savings plan is a common and popular choice. Money added to a 529 plan grows tax free, and distributions for college or other educational expenses come out tax free. A state tax deduction for contributions is also possible depending on the state in which you reside. Sounds great, but what if your child gets a scholarship, joins the military, or does not go to college? The earnings from the 529, when distributed, will be taxed along with a 10% penalty because they are not going towards your child’s education. Ouch. Moreover, with a 529 account, you are limited to the investment choices offered by the plan. These may or may not be in your best interest, especially when considering underlying costs of such investments. Additionally, even when accessing the money for your child’s college education, care must be taken to use the money only for qualified educational expenses or risk incurring a 10% penalty.
How about Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) accounts? These saving accounts are sometimes used for college planning. With these accounts, money is gifted to the child, who can take possession of the funds when becoming an adult (age 18 or 21 depending on the state). At this point the young adult is free to spend as he or she wishes––buy a Harley, get tattoos, or if you’re lucky pay for college. Some of the earnings from these accounts grow tax free (the first $1,050 for 2016) and some at the child’s tax rate (the next $1,050), but after that the earnings are taxed at the parent’s tax rate. Depending on the tax bracket you fall into, this method of saving could prove quite unfavorable.
Another option is the Coverdale Education Savings Account (ESA). With the ESA, contributions grow tax free and come out tax free for qualified education expenses. The rules for qualified expenses are different compared to 529 plans and in some ways are more restrictive. The ESA is also limited to a maximum $2,000 per year contribution limit per child, which probably won’t cover much of your child’s college expenses.
To further complicate matters, the accounts above can have different effects when calculating student financial aid––and to make things worse the rules regarding financial aid can change over time. Who knows what the rules for financial aid will be by the time your child starts college!
Here’s where a Roth IRA can help. The Roth IRA has some unique features that make it a great savings tool, regardless of purpose. What you put into a Roth IRA can be taken out at any time, without any tax consequences or penalties regardless of the reason for the distribution. That does not apply to the earnings, but we will talk more about that later.
There are eligibility rules to be able to contribute to a Roth IRA, and before contributing you will need to check the IRS rules to see if you qualify. The maximum 2016 contribution for those under 50 years old is $5,500, and those 55 and older $6,500. Your spouse can also contribute the same amount to the Roth IRA account based on his or her age. Those contribution amounts go up over time in $500 increments based on inflation.
Let’s say you and your spouse contribute the maximum amount ($5,500 each) into a Roth IRA for 18 years starting when your child is born. The contribution amount allowed will go up with inflation, but let’s assume there is zero inflation for this example. At the end of those 18 years, you and your spouse would have saved $198,000 in the Roth IRA, not counting earnings on those savings. If the account earned an average of 6% per year, then the account would be worth $360,360. Not bad.
Since you can withdraw the principal with no penalty or taxes assessed, you have easy access to $198,000. The balance ($162,360) can be used for retirement or, if you needed, used to pay for qualified education expenses. In that instance taxes would be owed on any earnings withdrawn before you reach the age of 59 ½, but there would be no penalty. However, it is usually recommend to withdraw the non-taxable principal only and not the taxable earnings whenever possible.
Since these assets are in a retirement account, here’s another benefit: they are not included in the calculation for determining student financial aid until after they are withdrawn from the account. If your child qualifies for student aid, you can hold off taking a distribution, which can make financial aid calculations more favorable for your family. If waiting to take a Roth IRA distribution is determined to be optimal, you can then use other assets to pay for school such as current employment income, other savings accounts, or even low interest loans.
Let’s consider a best possible scenario. Your child is accepted to the University of Michigan, your debts are all paid, and your income is high enough to pay for educational costs out of pocket. The Roth IRA wouldn’t be needed at all, and you would have an extra $360,360 that can continue to grow tax free and be earmarked for retirement!
Now let’s think about a worst-case scenario. Your child gets into Michigan State University (kidding!) and you lose your job at about the same time and without enough savings to cover living expenses while unemployed. Now what? Since your income is presumably low, your child should qualify for some aid in the form of grants and/or loans. Your Roth IRA would also be there to save the day, since you can take distributions from the principal with no penalty or taxes. This can be an effective back-up plan in addition to your emergency savings. If you are worried about the distributions counting against college financial aid options, you may be able to write an appeal to the college’s financial aid department. By explaining your situation it is possible to obtain favorable financial aid results based on your hardship.
The Roth IRA offers much flexibility and should be considered as a college savings tool, especially when financial resources are limited. Talk with your financial professional to see if a Roth IRA makes sense for you.
At Portfolio Solutions®, we provide a full spectrum of wealth management and financial advisory services so that our clients can work confidently toward their long-term financial goals. Our low-cost, index investment strategies allow our clients to keep more of what the global markets offer, letting them focus on what matters most to them.
Portfolio Solutions® does not provide tax advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax advice. You should consult your own tax advisor before engaging in any transaction.
