The Roth IRA is a tax-deferred account that can be used as a savings vehicle for college, similar to a 529 plan. When you need money to pay for college expenses, you can consider using your Roth IRA. It is designed to help you save for retirement with tax advantages, but it is possible to use the money in your account to fund college costs for you, your spouse, or your children. Before you take money out of your Roth IRA to pay for college tuition or other education expenses, it is important to understand the pros and cons. Working with a financial advisor while preparing college funding is a great idea.
Another strategy is to use a Roth IRA as a supplemental savings tool for a 529 plan. For example, you could contribute half of your college savings allocated to a 529 plan and half to a Roth IRA. This would help you achieve greater diversification with your college savings by distributing money among a wider variety of investment instruments. A Roth IRA can be used to save for college, even though it is intended for retirement savings. It provides the flexibility to use the money for retirement if the child chooses not to go to college or if there is money left after graduating from college.
For many Americans, ignoring the Roth IRA as a college savings technique is an unfortunate mistake. For starters, Roth IRA funds can be invested in stocks, bonds, mutual funds, ETFs and many other options, so money has the potential to grow and increase over time. An alternative solution is to wait until the distribution of a Roth IRA account no longer affects eligibility for assistance. The biggest disadvantage of using your Roth IRA, or any retirement plan, to pay for college is that you're spending money from your retirement savings. Money in a Roth IRA is not reported as an asset on the Free Application for Federal Student Aid (FAFSA).
Because Roth IRAs are financed with after-tax money, account holders can withdraw their contributions (but not their earnings) before the standard retirement age of 59 ½ without paying taxes or penalties. Young investors, including teenagers, can really take advantage of a Roth IRA because they pay taxes now, when they're likely to be in a low tax bracket. If you withdraw funds from the Roth IRA before age 59 and a half, any money you have earned from your investments will be taxable based on your current ordinary income tax rate and the 10% penalty. The IRS has some rules in place that govern withdrawals from Roth IRAs, and it's important to know how they apply to distributions made for college expenses. If you use a Roth IRA withdrawal for qualified educational expenses, you will avoid the 10% penalty, but you will continue to pay income tax on the income portion. One such exception extends to the use of Roth IRA distributions to pay for qualified higher education expenses. With the change from the FAFSA to the use of tax and income information from the previous year, distributions from a Roth IRA after January 1 of the junior year in college will not affect eligibility for need-based aid, assuming the student will not go to graduate school within two years after graduation from undergraduate school.
However, using a Roth IRA to save for college may backfire and cause reductions in eligibility for need-based financial aid.