When it comes to saving for your kids college savings, most financial advisors will put college savings a notch below saving for retirement. Wouldn’t it be nice if there were a way that you could do both without potentially risking one or the other?
Using your Roth IRA as a college savings vehicle could be one such option.
When you withdraw money from your Roth IRA to pay for your children’s college, you can withdraw your contributions without tax or penalty.
If you put $5000 per year into your Roth, over a 15 year period you could theoretically withdraw up to $75,000 because this is your total contribution.
Advantages of Using a Roth IRA for Kids’ College Savings
Flexibility to Make Important Financial Decisions in the Future
If you save in a Roth, the money is there to be used according to your child’s actual need. If your little girl gets a half off tuition scholarship, her school costs will be dramatically less than you would have anticipated when she was in diapers.
Here are some frequently asked ‘what if’ questions regarding a child’s college savings:
- What if she doesn’t go to school?
- What if she isn’t deserving of the money?
- What if you work for the school and get big discounts because of it?
- What if she has her own money to pay for school? You kids do plan to work in school, right?
With the Roth you can use what you have available based on the need when she is 18 instead of trying to guess when she is 2.
What happens to money in a Coverdell ESA if my child doesn’t go to school or use the money?
If your child does not use the money for school, you can roll the money over to a relative’s school payments. But, seriously, if you had been saving for your niece, do you think you would have intentionally contributed as much to college savings?
Contribution Limits
In 2010, the Roth contribution limit is $5,000. For a married couple, this means they can contribute up to $10,000 per year. Compare this to the Coverdell ESA which only allows you to contribute $2,000. Families who are not fully maxing out their contributions can use some of their allowance for college savings. Since my wife works at home there is no way we will max out $10,000 on my income.
Possible Financial Aid Advantage
When applying for financial aid, part of the decision is made on the assets of the family. Currently, a Coverdell ESA will be considered an asset when applying for loans. Funds in a Roth IRA will not – at least until withdrawn. As such, when you first apply for financial aid, if the money is in the Roth it will not be considered an asset when it comes to the financial aid decision. However, if you then withdraw the money, that amount of money would be considered an asset the next year when you applied. One obvious way around this is to get student loans and not touch any of your Roth IRA money until after your child was done with school and then withdraw the money to pay off those loans. This is something you will want to look into very carefully to be sure you completely understand how your choices impact financial aid.
More Options in a Financial Crisis
Since the future is unknown to us, if something happened along your way to saving for college and you were unable to continue to work or have bill payment issues, the Roth will provide some important savings for you.
It is better for your kid to work and borrow a little bit of money to go to school than for you to end up without any money at retirement.
Paper Work Reduction
Rather than having, maintaining, and opening multiple accounts, you can just do it all in one account – your Roth. In addition, you will not need to pay extra account and transaction fees as they will be included in an already existent account.
Disadvantages of Using a Roth IRA Instead of a Coverdell ESA to Save for Your Kids’ College
Savings Limitations
If you have more than a couple of children, the Roth IRA might not leave you enough room (within the contribution limits) to contribute for your retirement and each of the kids.
Limited Tax and Penalty Free Withdrawals
You will need to do the math and see if there is a likelihood that your contributions will not be enough. If it comes to pulling out more than your contributions to pay for higher education, then you will pay penalties.
A Hybrid Approach: Coverdell ESA and Roth IRA to Fund Kids’ College
Several factors make the hybrid approach appeal to me:
- I’m not going to do all the saving through a Roth IRA because I’m not sure if the contributions will be enough to help with the school costs of all three of my kids.
- Because I have three kids, I’d rather have a gap somewhere in case one of my kids doesn’t got to school or gets a good scholarship. Partially funding two ESAs and then funding a third through my Roth IRA allows me to enjoy the best of both worlds.
- I don’t really feel like opening and maintaining another account for my third child. If there is already a good savings vehicle in place, (my Roth IRA) why go to the effort to open something new that will be even more restrictive than what I have in place?
Our family goal is to help make the necessary preparations so our kids can graduate college with little or no student loans.
Before I go ahead with this plan, I want some feedback from my readers – does the Roth IRA sound like a good way to save for your kids’ college? Specifically, is using it for 1 out of 3 kids’ savings a good idea?
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{ 12 comments… read them below or add one }
Hi Craig,
You raise some very interesting points regarding using a Roth IRA for college savings. I would like to raise some additional considerations. First, Proverbs 3:27-28 teaches us to not withhold good from those who deserve it. “27 Do not withhold good from those who deserve it, when it is in your power to act. 28 Do not say to your neighbor, “Come back later; I’ll give it tomorrow”— when you now have it with you.” Personally, I am concerned by our willingness to “hide” assets from those who provide us with benefits, the government, higher education, etc.
Second, your child has to have earned income in order to contribute to a Roth IRA. If your child doesn’t have earned income, Roth IRA is not an option.
Third, if you withdraw only contributions you are not investing, you are only setting money aside in a 0% interest account. If you withdraw gains, they you are hit with a 10% penalty and taxes.
Finally, if my child was preparing to graduate with student loans and with contributions in a Roth IRA, I would definitely consider advising my child to withdraw only contributions from the Roth in order to pay off/down the student loan debt. The Roth IRA gains would continue to grow and I would rather have my child make payments to their Roth than to a lender.
I hope this helps and I look forward to future comments.
As always, this is a heady area and you should seek the advice of a competent financial professional.
Interesting scenerio, have been enjoying your posts as they make me think. For me I really want to teach my kids not to use debt as a tool.
My other thought is what % of your income are you saving for retirement? We are using Dave Ramseys 15% as our bench mark and currently we wont hit the $10,000 either. I want to be a good steward and not hoard money when it could be used now nor do I want to get to end of life and be a burden when I had the opportunity to wisely save.
“Third, if you withdraw only contributions you are not investing, you are only setting money aside in a 0% interest account.”
Cedric – I’m sorry, this doesn’t sound quite right. If my child will need $100K in 20 years (to keep math easy) and I choose this route, at 10%/yr return, I’d have $286K. $100K for school, $186K to stay in the account for retirement. The gains stay in the account.
Craig, an interesting approach. So long as the investor doesn’t double count those funds. With a $16.5K 401(k) cap, most people can fund their retirement that way and have the Roth as you suggest. If they don’t have access to a 401(k), the IRA/Roth IRA may be all they’ll have.
The concept of Roth as dual purpose account makes sense. Even as emergency fund. If no emergency comes up, the money generates tax-free gains, if it does, no harm done.
Hi Joe,
Please allow me to clarify. With a Roth IRA, you could only withdraw contributions without penalty in order to pay for college.
You are correct. My analogy isn’t the same for gains. The gains from your contributions would still be in the Roth IRA. The gains in a Roth IRA would make the Roth IRA better than setting money in a 0% interest account. My analogy is the same for the contributions, because you couldn’t use the Roth IRA gains for college without penalty.
If there are two options to save for college: (1) a Coverdale or 529 where my contributions produce gains and I can use both the contributions and gains to pay for college, or (2) a Roth IRA which would penalize me from withdrawing gains, (1) tends to provide more benefit than (2) based on some of these considerations.
Thank you for the correction. By the way, I enjoy your Personal Finance by the Book blog.
Cedric
@Gholmes
We are in-line with the Ramsey suggestions – give or take a % here or there.
@Cedric
Thanks so much for your feedback.
The “hiding” assets is a very good point – one that I thought of when I wrote the article. I agree that using the plan I laid out would be intentionally deceptive and thus would not be a wise moral or ethical move. I guess it is strange that I even included it, because as I wrote the strategy I knew it was not one that I could ethically use. Just something I read and passed along. Perhaps in the future I shouldn’t pass along strategies that are unethical! What was I thinking?
If you saved with a Roth IRA those funds would not be considered as assets for the child’s first year of school simply because they are not included until withdrawn from your Roth – when you pay the first bill. At that point your financial aid would already be determined. If a person had a problem with this they could withdraw the money early in the summer before they even started making applications (but, they would have no idea how much would be qualified deductions because they would not know the total school bill). If a parent wants to let a child work through college to see what is left then this would provide a possible financial aid benefit.
In this post, what I am suggestion is using my Roth IRA as a savings vehicle not opening one from my child. As you said, the child must have an income to make Roth contributions. Sorry that I did not make this point more clearly.
On your third point, the Roth IRA will be gaining interest, but basically all I would be doing is saying I don’t want to take out the interest only the principle. Thus, funds in an education savings account and a Roth IRA would both earn the exact same amount of interest. For example, if I had $75,000 in contributions and $25,000 in gains when I pay for school I would just say I want this money to come out of the $75,000 portion of the $100,000.
Again, sorry for not making it clearer that the intention is to use my Roth IRA to save for them. Instead of making contributions to their ESA I would make the same amount of contributions to my Roth IRA.
@Cedric
I just replied to your last comment and then saw this one.
The biggest problem with the ESA or 529 is that they are not flexible if I don’t use the money for education. In my situation there is a good chance that my kids will not even go to school in the states (they are all Canadian and US citizens).
If I plan to take $30,000 out for their schooling and put in $22,000 then it is all a wash if I take the money ($30,000) out of a Roth or ESA – as long as I have contributed more than $30,000 to the Roth.
Thoughts?
Craig
I’ve been struggling with how to manage our kids college savings. I had considered this approach in an all or nothing sort of way and decided against it and opened an ESA for our oldest (2.5). But the more I thought about how saving for our second (newborn) I was having trouble. We are pretty much following the Dave plan and are putting 15% into Roths and will be a little short of the $10K cap. So it was bothering me that I might be putting money into an ESA, not knowing how it may be needed (or not needed) by my children, but not maximizing our Roths.
This hybrid approach is the solution I needed. One ESA & max’d out Roths for our 2 kids. Thanks for the good write up.
@JoeTaxpayer “The concept of Roth as dual purpose account makes sense. Even as emergency fund. If no emergency comes up, the money generates tax-free gains, if it does, no harm done.”
Using as an EF, hadn’t thought about that at all, thanks for the idea.
.-= LRGCHE´s last blog ..lrgche: Approaching single digits on email on a Fri morning now that’s progress people! Ready for the weekend, just wish it would be a warm one #fb =-.
Hi Craig,
Your responses make perfect sense. Your proposed strategy could work well for parents who have over-contributed to retirement savings. No use in building bigger retirement barns.
Your second post regarding ESA and 529 plans as not flexible enough for your situation is very intriguging. I’m sorry I don’t quite follow the example though I am interested in discussing it further. I’ll send you an email.
If your income increases you will probably need to go with an ESA in the future, but for now using the hybrid approach sounds like it will work well for you too.
You can withdraw money out of a Roth IRA for these below reasons without incurring a 10% penalty… which is a good piece of mind provided by roth ira plans.
8 Exceptions that Eliminate the 10% Early Withdrawal Penalty
There are 8 exceptions to the 10% early withdrawal penalty (i.e. withdrawals that are taken before the age of 59 and 1/2). They are for distributions that:
i) Are taken because of the IRA owner’s disability
ii) Are taken because of the IRA owner’s death
iii) Are a series of loan repayments made over the life expectancy of the IRA investor
iv) Are used to pay for unreimbursed medical expenses that exceed 7.5% of the adjusted gross income of the Roth IRA owner
v) Are used to pay for medical insurance premiums if the IRA investor has been unemployed for more than 12 weeks
vi) Are used to pay for the purchase of a principal residence (maximum of $10,000 can be withdrawn). Also, the IRA investor must not have previously owned a home within the last 24 months.
vii) Are used to pay for higher education expenses of the IRA owner or eligible dependants/family
viii) Are used to pay back taxes of an IRS levy placed against the IRA
@Muneer
Thanks for the helpful list. The flexibility on withdrawals is one of the best features of the Roth.
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