Is it Okay to Use a Roth IRA to Pay for College Expenses?

The Pros and Cons of Using Roth IRAs for College Planning

College savings requires a plan. Creative RF/JGI/Jamie Grill

Should a Roth IRA be used to help pay for college expenses?  This is a question considered by many parents and grandparents as the price tag for higher education continues to rise.

The Roth IRA is an excellent way to save for retirement in an account that provides significant tax diversification benefits.  This is due to the fact that Roth IRAs offer-free withdrawal of earnings. Roth IRAs may also be used for non-retirement purposes using some strategic financial planning to help pay for other important goals such as funding college for a loved one.

The decision to contribute to a Roth IRA is driven by more just the tax-free growth of earnings. Another added benefit of the Roth IRA is the flexibility these retirement accounts provide when it comes to accessing your original contributions. Tax-free growth of earnings only applies if your account has been opened for at least 5 years and distributions occur after age 59 1/2.  However, Roth IRA contributions are made with after-tax dollars so they can be taken out anytime without tax or penalty. This creates an opportunity to use a Roth IRA as a supplemental source of college funding or any other non-retirement related financial goal.

Core Financial Planning Moves to Make Before Saving for College

Before we examine whether or not it makes sense to use a Roth IRA to pay for college it should be noted that most financial planners agree that you should have a solid financial foundation in place before considering the participation in any savings plan for college.

  The general guidelines are that this basic foundation should include the following steps: 

  1. Establish some funds to cover emergency expenses (think “starter” savings; usually $1-2k in savings).
  2. Contribute enough to a retirement plan at work to capture the full employer match if available.
  3. Eliminate any high-interest consumer debt such as credit cards or personal loans (e.g. greater than 6%).
  1. Fully fund your emergency savings account with enough money to cover 3-6 months of living expenses.
  2. Save as much as you can in a 401(k) or 403(b) plan, IRAs, and health savings account (somewhere in the range of 10-20% of pay or more is ideal) to meet retirement goals.
  3. Protect your family and your wealth by maintaining life, health, disability, and liability insurance.
  4. Create and maintain crucial estate planning documents such as wills, living wills, and powers of attorney that are current and up to date. 

For more information on prioritizing your financial goals, check out this helpful resource (see How to determine your financial priorities).

Retirement Planning Is Usually a Higher Priority than College Planning

 Before setting aside any money for college, you should first check to see if you are on the right track to meet retirement income goals. Many financial research reports have found that the majority of parents are not confident they are on track to reach their goals for retirement (see . This is the reason that saving for college often takes the backseat to saving for retirement. While it is possible to borrow money for college it is not wise to rely on debt to fund your retirement dreams.

 So as a general rule, retirement goals should take precedent over college savings on the priority list.  

Putting retirement ahead of college on the priority list isn't always the type of financial guidance parents or grandparents want to hear. This is usually because most parents are innately predisposed to provide children with the best experiences and opportunities possible. There can be some pretty bad consequences when you put saving for college ahead of retirement on the priority list.  Some of the negative outcomes include delaying retirement (or not enough money to retire on your terms), selling investment property or other assets earlier than desired, and the biggest potential consequence is unnecessary financial stress and frustration. 

The good news is that Roth IRAs provide parents with an opportunity to feel like they are making some progress saving for retirement in an account that can also be used to help pay for college.

 

How to Save for Retirement and College With a Roth IRA

People love the concept of "tax-free" and as a result, Roth IRAs are increasingly becoming one of the more popular savings vehicles for retirement. Contributing to a Roth IRA can give you peace of mind that you are at least doing something to save for future college expenses when other more important financial priorities exist. This option is ideal for parents who are behind on their retirement savings goals but they already have their core financial foundation in place (i.e. have an emergency fund, minimal debt, and at least contributing up the 401(k) match at work).  Using a Roth IRA to supplement college savings is also a consideration for parents or grandparents looking for more flexibility in how funds can be used compared to other options such 529 college savings plans. 

Pros:

Here are some of the benefits of using a Roth IRA as part of your college savings plan:

Roth IRAs allow for the flexibility to take out original contributions tax and penalty free. Your earnings in a Roth IRA only grow tax-free if your account has been opened for at least 5 years and distributions occur after age 59 1/2. However, since your contributions have already been made with after-tax dollars they can be taken out anytime without tax or penalty. Withdrawals from a Roth IRA are considered to come from contributions first. This means you have the ability to withdraw the sum of your contributions at any time without tax or penalty. 

Money grows tax-deferred and potentially tax-free. Roth IRAs allow you to contribute after-tax dollars that can grow to be tax-free as long as you meet the age 59 ½ rule and had the account for at least 5 years.  If you have multiple goals like paying for college and saving for retirement, you can access the original contributions using the strategy mentioned above while allowing the earnings to continue growing tax-free for longer term goals such as retirement.

Roth IRAs provide more control over investment options.The majority of 529 plans have a limited amount of investment options to choose from. Roth IRAs are not an actual investment but instead represent a type of retirement savings account that allows for various types of investments (stocks, bonds, mutual funds, ETFs, REITs, CDs, etc.).  In order to take full advantage of the tax-free growth of earnings, it is generally wise to seek out growth-oriented investments for a Roth IRA.

Cons:

Like many financial decisions, there are some downsides to using a Roth IRA to help pay for college.  Here are a few of the cons of this strategy:

Roth IRAs are subject to income limitations. Roth IRAs have income limitations which make married couples filing joint returns ineligible to contribute directly to these accounts if they earn above $194,000 in 2016 (note: the backdoor Roth IRA is one way around these limits).  Perhaps the biggest downside risk of using a Roth IRA to help pay for college is that you could delay the transition to retirement if you do not have a sufficient retirement nest egg available after any withdrawals to pay for college. 

Contributions are limited to $5,500 per year ($6,500 for ages 50 and older). Roth IRAs have lower contribution limits than other college savings vehicles.  Roth IRA contribution limits are significantly lower than the higher limits found with 529 college savings plans. Another problem found when using Roth IRA contributions to pay for college expenses is that the distributions count as untaxed income on next year's FAFSA and this could reduce your child’s eligibility for need-based financial aid. Roth IRAs are still a low impact asset for financial aid purposes and the total asset value is not reported on FAFSA.

529 plans are usually a better option when saving for college is the primary goal.  For a funding strategy that is solely geared towards paying for college, the 529 college savings plan is often a better option.  529 plan investments grow tax-free and distributions used to pay for qualified education expenses are also tax-free.  For parents or grandparents already on track to meet retirement goals it is usually more beneficial to look at 529 plans first for college savings.  But when those college funding goals require a little more flexibility or the likelihood of your child attending college is less certain a Roth IRA becomes more appealing.

We all have a variety of life goals that are constantly competing for our hard-earned money.  Roth IRAs are worth considering if you are looking for a tax-advantaged account for retirement savings with the flexibility to access those funds to supplement college funding objectives. When more important financial priorities exist that are higher priorities than saving for college, saving in a Roth IRA can at least give you peace of mind that you are taking some steps to save for future college expenses and your own retirement.