A Roth IRA helps you save for retirement by offering tax-free accumulation and withdrawal of earnings. It may also be used for non-retirement financial goals, such as funding college for a loved one.
But should a Roth IRA be used to help pay for college expenses? This is a question faced by many parents and grandparents as the price tag for higher education keeps rising.
Learn the pros and cons of paying for college out of your Roth IRA.
How to Use a Roth IRA for College Expenses
A Roth IRA is a tax-advantaged retirement account that anyone with an earned income (up to a certain threshold) can contribute to.
However, when you withdraw money from a Roth, you can actually use those withdrawals to pay for any expenses. This includes college expenses for a child or other beneficiary. There is no penalty for using these funds for college expenses.
You should have a solid financial foundation in place and a plan to save for retirement before getting started with any savings plans for college. Remember: While it is possible to borrow money for college, it is not wise to rely on debt to fund your retirement.
How much you can withdraw from your IRA to pay for college expenses depends on how old you are. That is because the money in your Roth IRA falls into one of two categories:
- Contributions: The money that you invested in the IRA.
- Earnings: The interest that your contributions generated.
You can withdraw contributions from your IRA at any point without paying any taxes or penalties.
In most cases, if you withdraw the earnings before you reach age 59 1/2, you will have to pay a 10% early withdrawal penalty. You'll also need to pay tax on the earnings. If you use those early withdrawals for qualified education expenses, you won't have to pay the penalty. However, you will have to pay income tax.
Both contributions and earnings from a Roth IRA can be used to pay for college. If you are under age 59 1/2, you should only withdraw your contributions in order to avoid paying income tax on early withdrawals of earnings.
Pros and Cons of Using a Roth IRA for College
There are both pros and cons to using a Roth IRA to help pay for college.
Contributions and earnings grow tax-free
More investment options
Contributions can be withdrawn any time tax-free
Withdraw earnings early with no penalty fee
Lower contributions limits
Reduces financial aid
No state tax deduction
Can cut into retirement savings
Taxes for early withdrawal
- Flexibility: Roth IRAs don't have a single designated beneficiary. That means they can be used to help pay for multiple students' expenses, not just one. Any money that you don't need for college can still be used for retirement.
- Tax-free growth: You pay tax on money put into an IRA when you earn that income. When you withdraw it, you do not have to pay any more in taxes.
- More investment options: The majority of 529 college savings plans offer a limited amount of investment options to choose from. Roth IRAs allow you to choose from many types of investments: stocks, bonds, mutual funds, ETFs, REITs, CDs, and more. This can give you more opportunities for more aggressive investments that can grow your money quickly.
- Tax-free withdrawals: Roth IRA contributions are made with after-tax dollars. That means these can be taken out at any time without tax or penalty. After age 59 1/2, earnings can be withdrawn tax-free. This is true as long as your account has been open for at least five years.
- Penalty-free withdrawals: If you withdraw earnings early for qualified education expenses, you won't have to pay the 10% early withdrawal penalty. But you will still have to pay income tax.
- Income limitations: Roth IRAs have income limitations that make married couples filing joint returns ineligible to contribute directly to these accounts if they earn more than a certain amount. This amount was $208,000 in 2021 ($206,000 in 2020). Single filers must make less than $140,000 to contribute to a Roth IRA in 2021 ($139,000 in 2020).
- Lower contribution limits: Roth IRAs have lower contribution limits than other college savings accounts. You can invest up to $6,000 per year or $7,000 if you are over age 50.
- Reduces financial aid: Roth IRA distributions to pay for college expenses count as untaxed income on next year's FAFSA. This can reduce your child’s eligibility for need-based financial aid. Roth IRAs are still low-impact assets for financial aid purposes; the total asset value is not reported on FAFSA.
- No state tax deduction: Unlike some state 529 plans, there's no state income tax deduction for contributing to a Roth IRA.
- Affects retirement savings: If you use money set aside for retirement to pay for college expenses instead, you would no longer have that money to fund your retirement.
- Taxes on early withdrawals: If you withdraw earnings for college expenses before age 59 1/2, you will have to pay income tax on the withdrawal. The same is true if you make withdrawals before your account has been open for five years, even if you are old enough
Using a Roth IRA vs. Using a 529 Plan
A 529 plan is a dedicated savings plan for education expenses. It is more common to use for that purpose than a Roth IRA.
|Roth IRA||529 Plan|
|No state income tax deduction||Tax-advantaged at the state level|
|Contributions and earnings grow tax-free||Contributions grow tax-free|
|Plans opened by young earners with low income qualify for a low tax-bracket||No income or age limits|
|Earnings withdrawn before age 59 1/2 are subject to income tax but not penalties (if used for qualified education expenses)||Withdrawals must be used for qualified education expenses to avoid penalties|
|Contributions can be withdrawn tax-free at any time; earnings are taxed if withdrawn early||No taxes on withdrawals of contributions or earnings for qualified education expenses|
|Many investment options||Limited investment options|
|Withdrawals can be used for any number of beneficiaries||Only one beneficiary per plan (can switch beneficiaries)|
|Contribution maximum of $6,000 ($7,000 for age 50 and older)||Contributions must be under $15,000 per year to avoid gift tax|
|Uses money that could otherwise be saved and earn interest for retirement||Grandparents or other relatives can contribute $75,000 one time to front-load the plan|
A 529 is a dedicated education savings plan. It is structured to allow you to save larger amounts for students than a Roth IRA is.
A 529 plan is also called a Qualified Tuition Program, or QTP.
Annual contributions are set by the state or the organization administering the 529 plan. Annual contributions over $15,000 may be subject to the federal gift tax.
This allows for much larger contributions per year than a Roth IRA. That means you can reach greater savings, earn more interest, and have more money available when your student heads to college.
A 529 plan also has different tax advantages than a Roth IRA. But it also has less flexibility. Withdrawals from a 529 must be used for qualified education expenses if you want to avoid paying a penalty. If your contributions and earnings end up being more than the beneficiary needs for their education, you'll have to pay tax on the difference.
A Roth IRA allows for more flexibility. But using it could cut into your retirement savings. This could leave you without enough income after you stop working.
Which Is Right For You?
For families who are on track to meet their retirement goals, it often makes more sense to open 529 plans first for college savings. But using a Roth IRA can add extra flexibility to your savings.
Which option is right for you will depend on your own financial situation. It also depends on what other retirement savings accounts you have available. If you are unsure which type of savings plan you should use, talk to a financial planner.