Using A Roth IRA To Save For Education Expenses

August 06, 2018

When it comes to saving for college costs, you probably think of 529 savings plans and Coverdell Education Savings Accounts (ESAs). After all, the earnings in these accounts can grow to be tax-free if used for qualified education expenses and you may receive a deduction on your state income taxes, if you qualify. However, they come with a significant downside. If you need the money for another purpose, you’ll have to pay taxes plus possibly a 10% penalty on any earnings you withdraw.

A quick review of Roth IRA rules

One solution is to use a Roth IRA for education savings. Since the contributions to a Roth IRA can be withdrawn tax and penalty-free at any time and for any purpose, including education expenses, it can be a great tool to save for some of those “what-if” goals. If you withdraw earnings before you’ve had the account at least 5 years or before you turn age 59 ½, you may have to pay taxes plus a 10% penalty on them (one exception is for qualified education expenses), but the contributions always come out first.

Other things to consider when deciding between Roth IRA & other education savings options

Flexibility

Using a Roth IRA to save for education gives you a lot of flexibility. If you need the money in an emergency, you can withdraw the sum of your contributions without tax or penalty. For qualified education expenses, you can use the remainder of the contributions tax and penalty-free plus earnings penalty-free (remember that you’ll pay taxes on any earnings withdrawn for education expenses if you’re not yet 59 ½). Anything you don’t withdraw can grow to be tax and penalty-free after 5 years and age 59 ½ and help to fund your retirement.

Financial aid eligibility

Unlike 529 plans and Coverdell ESAs, Roth IRAs are also not counted as assets in determining financial aid. However, withdrawals are counted as income, which could hurt future financial aid eligibility more than assets. The solution is to wait as long as possible to withdraw money from your Roth IRA so that as much of the financial aid as possible will already be awarded. It also makes sense to deplete 529 and Coverdell ESAs first.

Investment options

One downside of using a Roth IRA for education expenses is that you won’t have access to the age-based investment options that many 529 saving plans have. These funds simplify investing much like target date retirement funds in that they are fully diversified and automatically become more conservative as your child gets closer to college age.

You could invest in target date funds using the date when your child goes to college, but these funds will likely be too aggressive since the money can be withdrawn over a much longer time frame for retirement than for education. Instead, you’ll have to make the portfolio gradually more conservative yourself or work with a qualified and unbiased financial planner who can help you with that.

In any case, consider opening your Roth IRA at a discount brokerage firm like Vanguard, Charles Schwab, Fidelity, TD Ameritrade, or E-Trade that has a wide selection of low cost investment options.

This strategy is not for everyone

If you have sufficient emergency funds and know you will use the money for education expenses, a 529 plan or Coverdell ESA would probably make more sense since the earnings could be completely tax-free. Some states also give you a state tax deduction for 529 plan contributions (which is another tax-savings strategy discussed in this post). The important thing is to be aware of the pros and cons of your options so you can make the right choice for you.