Saving to the Roth IRA For Future College Expenses in the Parent’s Name
 

Saving to the Roth IRA For Future College Expenses in the Parent's Name
By: Karen Rinehart, CFP®
The Henssler Financial Group Position Paper

Roth IRA accounts are used primarily for individual retirement savings, but you can use the accounts for higher education savings. You do not want to use a Roth IRA account as your primary source of education funds, but a Roth IRA is a great account if you are trying to save for college and retirement.

To explore this concept, I will begin by reviewing the Basic Rules for a Roth IRA account. Contributions and earnings for a Roth IRA account have separate rules.

Basic Rules for Contributions:

  • Roth IRA contributions are not tax deductible.
  • Contributions can be withdrawn from a Roth IRA Account at any time. For example, if you deposit $5,000 in 2008 and 2009, you can withdraw $10,000 from your Roth IRA account in 2010 without tax or penalty because the $10,000 is the original contribution.
  • The contribution limits for Roth IRAs are as follows:
    • 2008: $5,000 per year, with a $1,000 catch-up contribution for those older than 50.
    • After 2008: The annual contribution limit will increase with a Cost of Living Adjustment.

Basic Rules for Earnings:

  • Distribution of earnings from a Roth IRA account must meet the following criteria to be tax-free and penalty free:
    • The distribution is made five years after the initial contribution and one of the following:
      • Distributions are made after attaining age 59½;
      • The account holder becomes disabled;
      • For the purchase of the account holders first home, or
      • The distribution is due to death.
  • Earnings can be withdrawn from a Roth account after five years without penalty but taxes will be due if the distribution is used for qualified higher education expenses.

When a distribution is made from a Roth IRA account, contributions are considered withdrawn first. For example, if you have an account worth $10,000 ($8,000 is contributed money and $2,000 is earnings) and you withdraw $6,000 today. There is no tax consequence or penalty as contributions are pulled from the account first.

Distribution for Higher Education — Examples Based on the Basic Rules:

Example 1: If you have held the Roth IRA account for five years or more and your child will attend college before you reach 59½, you will owe tax on the amount of earnings withdrawn from an account. Based on the example above, if you withdraw $10,000 from your Roth IRA for education you will owe taxes on $2,000 earnings. The $8,000 contribution will not be taxed.

Example 2: Assume the same information except you are older than over 59½; you will not owe taxes or a penalty on any of the money withdrawn from the account.

Saving to a Roth IRA in the Child's Name

If you are considering saving to a Roth IRA for your child, you should keep the following in mind:

  • In order to be eligible to make a Roth IRA contribution, you must have earned income. Therefore, you cannot set up a Roth IRA for a child when they are born, like you can an Education Savings Account, 529 Plan or custodial account. The Roth IRA account does not have as much time to grow as the other types of education accounts.
  • If you want to set up a retirement account and a college savings account for older children you can establish a Roth IRA for them if they have earned income. Earned income can be from outside employment or an allowance you pay your children for chores around the house. We do not recommend using a Roth IRA account for older children if the primary goal is to save for college education because of the contribution limit and the fact that the withdrawal of earnings could be taxable.

Advantages and Disadvantages of Using Roth IRA for College Expenses

Advantages of a Roth IRA

  • You can pool your savings for potentially larger earnings. If you cannot save more than $4,000 per year for retirement and college savings it makes sense to look at using a Roth IRA account. Your earnings will grow more quickly if you pool the money together. As long as you do not take out earnings, any withdrawals you make will be tax-free and penalty free.
  • The money is not restricted to education expenses. Any money not used for education is still in your control. You can spend the money on whatever you like after you turn 59½.

Disadvantages of a Roth IRA

  • You could end up paying hefty taxes. If you withdraw earnings before you turn 59½ you will pay taxes on the amount of earnings distributed. If you were to use a 529 Plan savings account you can withdraw the money tax-free as long as it is used for college expenses.
  • There are caps on how much you can contribute each year. The amount you can contribute to a Roth IRA is less than what can be contributed to a 529 plan. The cost of college is rising drastically, and the amount you can save to a Roth IRA annually might not be enough to cover the cost of college if you do not start saving early.
  • You're using retirement money to pay for college. The main purpose for Roth IRA accounts is to save for retirement. If you take money from the account, you will have less available for your own needs and lose out on potential earnings that would have come from investing money over time.
  • Impact on financial aid once you begin withdrawing money from the Roth. The value of a Roth IRA account is not included in the financial aid formula. It is not counted as the student's or the parent's asset. However, you cannot ignore the impact a distribution from a Roth IRA account has on financial aid. Once you begin withdrawing earnings from the Roth account, these distributions would be counted the following year as parental income even if the earnings were not taxable. Income is weighted more heavily in the financial aid formula and this could impact your child's financial aid the second year of school and on. You should keep the Roth IRA for retirement if withdrawing from the account creates a tax or financial-aid disadvantage.

Using a Roth IRA for College Savings – Sample Plan

If you chose to use the Roth IRA for college savings, the following is a sample plan:

Jim decides to use a Roth IRA for college savings and retirement. Jim can only afford to save $1,500 per year for retirement and $500 per year for college. Jim will consider one-fourth of the Roth account to be for college savings. When the time comes to pay for college, Jim will withdraw one-fourth of the account. From the perspective of the IRS, Jim is not withdrawing earnings until he takes more out than his original contribution. This means the distribution is tax-free unless his earnings have grown so fast that they equal more than one-fourth of the account. Jim has accomplished saving for college and accumulating earnings that will not be taxed.

If you save for college over a long period of time the benefit can be substantial as long as you do not withdraw earnings from the account. If you are saving for college and retirement, this strategy can be beneficial.

Bottom Line

Roth IRA accounts are a good option if your main concern is to prepare for your retirement and paying for your children's higher education expenses are second. The Roth IRA provides the greatest benefit when you can take advantage of withdrawing earnings tax-free. You may get some benefit from a Roth IRA even if you pay tax when you withdraw earnings, but the benefit is smaller. This is the problem with using a Roth IRA for college savings: You may have to pay tax when you withdraw the earnings.

You should consider what age you would be when your child will need the money for college. If you have the time and the means to save specifically for college you should consider a 529 Plan or an Education Savings Account. If the child is older you should consider using a 529 Plan account because of the higher contribution limit. For more information regarding this topic, please contact The Henssler Financial Group at 770-429-9166 or comments@henssler.com.

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
 
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