Using Roth IRAs for College? – MaybeDecember 4th, 2020 by Jim Allen
In the world of financial planning, retirement and college planning are often separate and possibly competing goals. For most advisors, the common wisdom is that you use retirement plans like your 401(k) and IRA for retirement goals, you fund college goals with 529 college savings plans and their paths should not cross. However, this isn’t always true and a common retirement planning tool, the Roth IRA, can serve double duty as both a college and retirement savings vehicle.
College Savings “529” Plans
When it comes to saving for college, the 529 plan is the big dog. It provides many benefits like tax deferred growth, potential state income tax deductions and tax-free withdrawals to pay for qualified college expenses. Most plans also allow you to make small systematic contributions or to front load the plan with large upfront contributions. The college expenses eligible for a tax-free withdrawal are broad including tuition & fees, books, laptops and some room and board. So, using a 529 plan as your primary source of college savings is a no-brainer.
But what if your child does not attend college or the money is needed for non-qualified college expenses like food, a car, or extracurricular activities? Then you will pay tax on the earnings as well a possible 10% penalty tax. For these reasons, having other funds available for ancillary needs is a good idea. Just like we want diversification for our investments and for tax planning, we should also diversify our college planning strategies. “Not putting all your eggs in one basket” applies to college planning just like it does to other areas of your finances.
The Roth IRA
The Roth IRA is a unique and popular retirement planning vehicle. Unlike the more typical retirement plans like an IRA or 401(k), Roth IRA contributions are not tax deductible. But, earnings grow tax deferred and you can take tax-free distributions after age 59 ½ as long as you have had the Roth for 5 years. The Roth also provides the additional benefits of no required minimum distributions and the ability to withdraw your contributions tax-free at any age.
There are also drawbacks to the Roth IRA since the maximum contribution is limited ($6,000 or $7,000 in 2020 depending on your age) and you cannot contribute to a Roth if your income is too high. When we are planning for a client’s retirement, we like to diversify tax treatment between pre-tax retirement plans like the 401(k) and after-tax, but tax-free later plans like the Roth IRA. Again, we don’t want to put all our eggs in one tax basket.
The Roth IRA for College Planning
While putting most of your college savings into a 529 plan is still a good idea, consider putting some into a Roth IRA as well. Why? – should your children not go to college, the funds you put in the Roth are still there for your retirement needs. However, if college does happen, you can withdraw your Roth IRA contributions tax free and use them to supplement your 529 plan savings. Unless you are over 59-1/2, withdrawals of the growth on your contributions would be taxable so you may want to leave the earnings in the plan and continue to grow them for retirement. Another benefit of a Roth contribution withdrawal is that they can be used for those expenses that don’t count as a qualified college expense under the 529 plan tax free withdrawal rules. This gives you some flexibility to spend for college needs that fall outside of the 529 plan rules.
Finally, contributing to a Roth IRA allows you to earmark the contributions for college if needed while still letting those contributions provide growth towards your future retirement needs. So, the Roth can serve “double duty” as both a college and retirement planning tool.
At Anchor Bay Capital, we pride ourselves on creating comprehensive financial plans that meet your individual goals and objectives. If you would like a complementary college or retirement consultation, please contact us and mention this article.
Jim Allen, CFP, ChFC, CDFA is the Director of Financial Planning and a Principal at Anchor Bay Capital. In addition to his 30 years of financial planning experience and his professional credentials, he holds a Master’s Degree in Financial Planning and is a former instructor in the CFP program at the University of California Irvine. He is also the co-author of the book “The Tools & Techniques of Charitable Planning.” Jim can be reached at [email protected]