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- Prioritize a Roth IRA over a 529 plan if you’re behind on retirement savings.
- If you’re 100 percent sure you’ll use the funds for education (K-12 or college), a 529 probably makes the most sense.
Among the many benefits of the Roth IRA is that you can use its funds to pay education expenses – without incurring any tax penalties. But should you? After all, 529 savings plans are designed specifically to help you save money for educational expenses. And both Roth IRAs and 529 plans let your money grow tax-free until you’re ready to use it.
If you’re behind on retirement savings and eligible to contribute to a Roth IRA, do that. In fact, don’t even read the rest of this article – just open a Roth IRA right now and set up regular contributions. Your kids will have far more options to fund their college education than you will to pay for retirement. Trust us.
If you’re on track for retirement, though, the decision becomes more nuanced. Here, we’ll examine the benefits and drawbacks of using a Roth IRA as a college savings tool and offer some insight into whether this investment strategy makes sense for you.
Refresher: what is a Roth IRA?
A Roth IRA is an individual retirement account named for Senator William Roth of Delaware, who was the main sponsor of the bill that made this investment vehicle possible. The Roth IRA allows for after-tax income contribution into an account, where it can grow tax-free. Investors can then withdraw the money tax-free in retirement.
The most obvious difference between the Roth IRA and the traditional IRA is that contributions to Roth IRAs come from taxed income, whereas traditional IRA contributions are made with pre-tax dollars. In retirement, funds in a Roth account can be withdrawn tax free, while retirees must pay taxes on funds withdrawn from a traditional IRA.
You can use both the traditional and Roth IRA to pay for college, but a Roth’s tax-free withdrawals make it more advantageous – and more similar to a 529.
How to use a Roth IRA to pay for college
Obviously, the primary intent of a Roth IRA is to fund your retirement. It’s right there in the name.
And in most cases, if you withdraw any of your earnings before your Roth IRA is five years old and before you are 59½ years old, you’ll pay a 10 percent tax penalty.
(Note: you can withdraw the basis, or the amount of money you pay into your Roth IRA, at any time without penalty; the pre-retirement penalty only applies to earnings – that is, interest your principal has accrued.)
But the Roth IRA also lays out certain exemptions to the early-withdrawal tax rule.
One of those exemptions states that if investors want to withdraw funds to pay for college – either for their own education or that of a close relative – they can do so without paying taxes.
The benefits of using a Roth IRA for college
So should you consider using a Roth IRA to fund college for yourself or a loved one, rather than a vehicle like a 529 savings plan? That depends on the specifics of your situation. First, let’s take a look at the benefits of using Roth IRA funds to help pay for college:
- Flexibility: If you’re choosing between a Roth IRA and a 529 savings plan, fund flexibility is one of the main benefits of the former. If you don’t end up needing the funds for college (because of scholarships, military service, etc.), you can use Roth IRA funds in retirement with no tax penalty. Money in a 529 account, however, can only be used for educational expenses. Withdrawing it for other purposes comes with steep penalties.
- FAFSA eligibility: Money stashed in a Roth IRA is not counted as an asset in Free Application for Federal Student Aid (FAFSA) forms, while money in 529 accounts is. So putting money in a dedicated 529 account could hurt your child’s ability to receive federal financial aid, whereas putting an equal amount in a Roth IRA account will not. Put differently, money in a 529 account will affect your Expected Family Contribution, while money in a Roth IRA will not.
- More investment choices: Roth IRAs let you invest in more or less whatever investment vehicles you want – stocks, bonds, ETFs, mutual funds, CDs, real estate, and so on. The main limits will be defined by the platform or brokerage where you set up your account (e.g., if you start a Roth IRA with Fidelity, you won’t have access to M1’s Expert Pies). With a 529 plan, you’re limited to the investment options offered by your state’s program.
- No fees: If you use a platform like M1 for your Roth IRA, you won’t pay any management fees as your money grows. Most 529 plans come with fees, which can eat into your earnings, reducing the amount of money you have available for college or retirement.
Obviously, there’s a compelling case for the Roth IRA as a college savings vehicle. But it’s not entirely cut and dried.
Drawbacks of using a Roth IRA to save for college
Despite its many benefits, the Roth IRA is not a perfect investment vehicle (spoiler alert: nothing is). Here are a few reasons the Roth might not make sense as a way to fund college:
- Lower contribution limits: People younger than 50 can contribute just $6,000 per year to a Roth IRA (those 50 and older can contribute $7,000). A 529 plan, on the other hand, has much higher limits (they vary by state, but range from $235,000 to $529,000). One thing to note: if you plan on contributing $15,000 or more in a year, you may be responsible for gift taxes.
- Income limits: The other major snag for the Roth is that certain high earners aren’t eligible for this investment vehicle at all. As of 2019, if your gross household income is above $137,000 as a single person or $203,000 as a married couple filing jointly, you aren’t eligible to contribute. If you earn $122,000 as a single person or $193,000 as a married couple, you won't be able to contribute up to the full limit. There are no such income limits for 529 plans.
- No income tax deductions for Roths: Contributions to a Roth IRA happen with money on which you’ve already paid income tax, meaning you get no income tax deduction for your contributions. With 529 plans, though, many states let you deduct some or all of your contributions from your state income taxes.
- Roth withdrawals can hurt financial aid eligibility beyond year one: While having money in a Roth IRA doesn’t hurt financial aid eligibility, taking withdrawals does. Those withdrawals count as income, which can impact the amount of aid you or your child qualify for because it is perceived that you earned more in that year. Because of this, a 529 plan is probably the better choice if you are 100 percent certain that you’ll be using money for college (but it’s rare to impossible to have 100 percent certainty about future financial needs).
- Sacrificing your retirement savings: It’s hard to understate the importance of this point. If paying for a child’s college with Roth IRA funds will seriously hurt your ability to support yourself in retirement, then paying for college is probably not a good use of those funds. After all, students have a variety of loan options available to them, and while paying loans back is a financial burden, so is supporting a parent who lacks retirement funds.
So… should you open a Roth IRA?
If you’re eligible to contribute to a Roth IRA and have not yet done so, that should be your first step before contributing to an educational savings plan like a 529. Retirement is an important goal, and money you put in a Roth IRA can always be used for educational costs in a pinch – whereas the reverse isn’t true.
Interested in opening a Roth IRA today? Do it here.
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