College Savings: Pros and Cons of Using a Roth IRA

In prior posts, we have mentioned the benefits of using 529 accounts for college savings. The primary advantages are that 529 account owners avoid tax on investment gains (provided the funds are used for higher education) and, in many states, they receive a state income tax deduction on contributions to the account. However, what about states in which there are no 529 income tax deductions or no state income tax at all? Are 529 accounts still the best college savings option? In this case, using Roth IRAs for college savings may be a good option. Below are some pros and cons to this approach.

Pros. While Roth IRAs are structured primarily for the purpose of retirement savings, higher education expenses do fall under one of the exceptions for early withdrawals. Therefore, similar to 529s, investments in Roth IRAs can grow tax-free and withdrawals for college expenses will not face any taxes or penalties (provided the funds have remained in the Roth IRA for five years or more). In addition, this tactic provides greater flexibility than 529s with respect to uses for the funds. If, for instance, your child receives a scholarship or chooses not to attend college, Roth IRA funds can be used for retirement or another qualified exception and still avoid taxes on the investment gains. In contrast, if 529 funds are not used for higher education, you will have to pay taxes on investment gains, even if you are able to avoid the 10% penalty for non-qualified withdrawals. Finally, since Roth IRAs are considered retirement assets, they are currently not included in the calculation of your expected family contribution for financial aid, though withdrawals from Roth IRAs to pay for college would be included as “income” in financial aid determinations for the following year.

Cons. Using Roth IRAs for college savings, however, will inhibit your ability to use IRAs for retirement savings, which may be problematic, especially if you do not have access to an employer retirement plan. If you are under age 50, you can only contribute a total of $5,500 per year to IRAs (either traditional or Roth), provided you earned at least that much in taxable compensation. Any portion of this amount saved for college cannot be saved toward retirement. Further, even if you have access to an employer retirement plan and could use the Roth IRA entirely for college savings, contributing $5,500 annually may not be sufficient to fund college expenses, especially if you have more than one child. In addition, some individuals may not even qualify for Roth IRA contributions because they exceed the income limits (which generally start at $131k or $183k, depending on your tax filing status). Finally, using the Roth IRA for college funding will also reduce the possibility of using it for estate planning. The biggest benefit we see from a Roth IRA is the long term stretch withdrawal strategy for a young beneficiary.  The ability to pay no tax on the growth of the account over the contributor’s lifetime and then continue the tax deferred growth over the beneficiary’s lifetime is a huge benefit. Spending Roth funds for college means there will be less, if not zero, left for the beneficiary.

For those living in Virginia or other states with income tax deductions for 529 contributions, we continue to recommend using 529s for college savings. But, for those who are living in states without income tax, desiring greater flexibility on the use of their funds, not relying on IRAs as retirement savings vehicles, and earning less than the income limits for Roth IRAs, saving for college via Roth IRA may be a beneficial alternative.