If you’re saving for college, you probably want to find the best way to maximize your savings and minimize your current and future tax burden. Here at Afton Advisors, we are big fans of Roth IRA investments.
After all, a Roth IRA is one of the best ways to save for retirement while also avoiding a huge tax bill on your earnings. However, what many people don’t realize is that a Roth IRA doesn’t have to be all about retirement.
Using a Roth IRA to Save for College
Though 529 plans are incredibly popular tools to help save for college, the one drawback is that they aren’t very flexible when it comes time to distribute funds.
A 10% excise tax (penalty) exists for non-qualifying distributions. Additionally, 529 plan assets count on the FAFSA and need-based aid calculations as an asset that increases the Expected Family Contribution (EFC).
This means that the assets you have set aside in a 529 plan would take away from any financial aid that you could receive.
Assuming your family qualifies for Roth IRA contributions, this asset can provide many benefits to help address these concerns:
The value of a retirement plan (like a Roth IRA) does not count towards the EFC formula. So, with a Roth IRA, you won’t have to worry about losing out on need-based financial aid for college.
Roth IRA’s need to be “seasoned” for 5 years before withdrawing any earnings…meaning the account needs to be opened and funded 5 years before you plan on using the earnings portion of the account. The rules here can be tricky, so make sure you are clear on them before distributing any funds.
Roth IRA accounts for parents under the age of 59.5, can be withdrawn according to a FIFO methodology (First-In, First-Out). In short, your contributions can be removed, free from taxation, before you must withdraw the earnings. What does this mean for you? Consider the following example:
If the sum of your contributions over the years is $50,000, but the account has grown to $65,000, then the first $50,000 you withdraw would just be a tax-free return of contribution. The next $15,000 withdrawn would be a withdrawal of earnings, which would contain income taxation if the parent is under the age of 59.5. While income taxes will be due on that $15,000, it will avoid the 10% penalty because the funds represent a qualifying distribution to help pay for education.
Finally, college planning doesn’t need to interfere with your retirement savings. Since the purpose of this account is for retirement, it may be helpful to devise a joint strategy whereby some of the assets will be used to help pay for education expenses while other assets (i.e. the earnings) will be used in retirement. This way, you can kill two birds (college and retirement) with one stone! In any case, it is important that your plan be comprehensive, so let us know if we can help!
Though many people assume that a 529 plan is the best way to save for college, they may not be considering the impact of the 529 plan savings on their Expected Family Contribution (EFC) when it comes time to apply for need-based financial aid. Additionally, if the child receives scholarships or decides against attending college altogether, the 529 would generate income tax and a 10% excise tax on non-qualifying withdrawals.
However, by using a Roth IRA account to save for college and retirement, you can help alleviate your tax burden while maximizing your EFC.