Roth IRAs are like the superheroes of the retirement investing world. They offer a large number of advantages over other investment vehicles like 401(k)s and 403(b)s.
But there are some particular advantages they have when it comes to paying for tuition.
To get a general idea of the Roth IRA’s advantages, check out this paper that T. Rowe Price put together showing how much more spendable income is available with a Roth IRA in retirement over traditional IRAs.
Besides the above benefits of a Roth IRA, in this article, we’ll focus on what makes a Roth IRA great for paying for college tuition - as well as discuss the drawbacks. Roth IRAs have perks, but just like 529 plans, they also have cons.
More Control Over Your Money With A Roth IRA
When it comes to saving for college tuition, there are a variety of options available. Here are just a few:
The problem with the first three is the loss of control of your money and penalties. The government basically locks away your money when you put it into a tax-advantaged account.
You can access it but there are usually steep penalties involved. You lose liquidity with these accounts. Anytime you need access to funds, you’ll have to pay for it.
The last three options provide for more flexibility but there aren’t any tax advantages.
Instead, what if you could have the flexibility of a savings account with tax advantages. That’s where a Roth IRA comes in.
Besides flexibility, Roth IRAs offer far more investment choices than the other mentioned tax advantages accounts. 401(k)s are restricted by ERISA and 529 and Coverdell plans have investment restrictions as well.
You might be wondering what a Roth IRA has to do with paying for tuition.
Let’s get into the details.
Paying Tuition With A Roth IRA
The way a Roth IRA works is that you add after-tax dollars into your Roth IRA account. The maximum amount you can contribute per year is $6,000 or $7,000 if you are over 50. See the Roth IRA Contribution Limits here.
The tax advantages of a Roth IRA come on the distribution side. When money is taken out of a Roth IRA, it’s tax-free. You can also begin removing money from a Roth IRA before age 59 1/2.
Sophia Bera, a CFP and founder of financial advisory firm Gen Y Planning, had this to say about withdrawing money from a Roth IRA, ”if an emergency comes up, you can actually take out the money from your Roth IRA and use it for any purpose.”
When it comes to a Roth IRA, distributions are already tax free (since they use after-tax money), so the goal here is to avoid penalties!
You can withdraw money to qualified higher education expenses at any time. See the full list of qualified higher education expenses here.
By maxing out a Roth IRA every year, you not only save for retirement but also leave an option open that allows you to pay for tuition.
Do Roth IRA Withdrawals Impact Your FAFSA
The FAFSA is the Free Application For Student Aid. It’s used to determine a student’s eligibility for student aid.
While a Roth IRA does provide great advantages when paying for education, there are a few things you’ll want to keep in mind to further maximize its benefits.
Withdrawals from a Roth IRA can impact your FAFSA, reducing the amount of financial aid you might receive.
Rick Wilder, the director of student financial affairs at the University of Florida, mentions ”Students who apply for need-based financial aid are required to report income and asset information on the FAFSA.”
Retirement accounts aren’t counted as assets on the FAFSA. However, withdrawals from a retirement account, such as a Roth IRA, are counted against the FAFSA.
A little planning ahead and possibly even speaking with an account can help to get the most out of the FAFSA and your Roth IRA for educational expenses.
The Big Drawbacks
First, there's always the question of "who's Roth IRA are we talking about?" What I mean bu this is, are we talking about withdrawing from the student's Roth IRA, or the Parent's Roth IRA.
Using A Student's Roth IRA
There are two big drawbacks to using a student's Roth IRA.
First, it's really hard to get money into a child's Roth IRA. There are a lot of rules about earned income, and when children are young, it's hard to fund a Roth IRA (or fund it fully). As children start working as teens, it's easier, but even then, the amount you can contribute is likely low.
Second, when you use the money out of the account, it counts fully as income for the child. So, you might get a benefit for a student going into their freshman year of college, but when filling out the FAFSA for their second year of school, they're going to have to fully report any amount withdrawn the previous year as income.
Using A Parent's Roth IRA
Beyond the FAFSA implications, the big drawback to using a Roth IRA for college tuition is that you're withdrawing from a retirement account "mid life". Since you are limited on how much you can contribute, do you think you'll make up the loss over time? It's tough to say.
For example, let's say you start saving the max at $6,000 per year right now and continue for 18 years. Maybe that's grown to $150,000 in total. That's awesome. But, if you start pulling out $25,000 per year for 4 years, you're now back down to $50,000.
Don't get me wrong, $50,000 for a 22 year old is awesome - but what is the lost opportunity cost of that extra $100,000?
Over 40 years, that $100,000 could have grown into $2,172,000 - tax free. And that's with no additional contributions! If you take that original IRA, continue adding in $5,500 per year, you get $4,682,000 at age 62!
If you start with the left over $50,000 and contribute $6,000 per year - you now only grow to $2,500,000. Not a bad return, but you end up losing 50% of your value potentially.
That's the big drawback. Pulling money out of a tax sheltered account like a Roth IRA "mid life" or "early life" really hinders future returns on that money. And that would be tax free money.
Given that there are other alternatives to save for college (like a 529 plan), this is something you really need to consider strongly.
Roth IRAs are great sources of funding for qualified educational expenses. To get the most out of them requires a little planning.
If you plan to use a Roth IRA mainly for tuition, you can maximize your tax advantages by opening the account at least five years before attending college. This way, you get not only tax and penalty free withdraws of contributions but also earnings.
Additionally, by withdrawing only contributions and not earnings, you minimize the impact on potential FAFSA student aid.
Would use consider using Roth IRA funds for high education expenses? Why or why not?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.