The Roth IRA as a College Savings Tool
By Len Nowak , CFP ®, AWMA ®, CTS™
When Congress enacted the Taxpayer Relief Act of 1997 , which included establishing the Roth IRA , they probably weren ’ t thinking about college planning . The Roth IRA was introduced with retirement in mind , but due to some unique features it can actually be a very good college planning and savings tool as well .
There are many ways to save for college for your children , each with pros and cons . The 529 college savings plan is a common and popular choice . Money added to a 529 plan grows tax free , and distributions for college or other educational expenses come out tax free . A state tax deduction for contributions is also possible depending on the state in which you reside . Sounds great , but what if your child gets a scholarship , joins the military , or does not go to college ? The earnings from the 529 , when distributed , will be taxed along with a 10 % penalty because they are not going towards your child ’ s education . Ouch . Moreover , with a 529 account , you are limited to the investment choices offered by the plan . These may or may not be in your best interest , especially when considering underlying costs of such investments . Additionally , even when accessing the money for your child ’ s college education , care must be taken to use the money only for qualified educational expenses or risk incurring a 10 % penalty .
How about Uniform Transfer to Minors Act ( UTMA ) or Uniform Gift to Minors Act ( UGMA ) accounts ? These saving accounts are sometimes used for college planning . With these accounts , money is gifted to the child , who can take possession of the funds when becoming an adult ( age 18 or 21 depending on the state ). At this point the young adult is free to spend as he or she wishes –– buy a Harley , get tattoos , or if you ’ re lucky pay for college . Some of the earnings from these accounts grow tax free ( the first $ 1,050 for 2016 ) and some at the child ’ s tax rate ( the next $ 1,050 ), but after that the earnings are taxed at the parent ’ s tax rate . Depending on the tax bracket
you fall into , this method of saving could prove quite unfavorable .
Another option is the Coverdale Education Savings Account ( ESA ). With the ESA , contributions grow tax free and come out tax free for qualified education expenses . The rules for qualified expenses are different compared to 529 plans and in some ways are more restrictive . The ESA is also limited to a maximum $ 2,000 per year contribution limit per child , which probably won ’ t cover much of your child ’ s college expenses . To further complicate matters , the accounts above can have different effects when calculating student financial aid –– and to make things worse the rules regarding financial aid can change over time . Who knows what the rules for financial aid will be by the time your child starts college !
Here ’ s where a Roth IRA can help . The Roth IRA has some unique features that
make it a great savings tool , regardless of purpose . What you put into a Roth IRA can be taken out at any time , without any tax consequences or penalties regardless of the reason for the distribution . That does not apply to the earnings , but we will talk more about that later .
There are eligibility rules to be able to contribute to a Roth IRA , and before contributing you will need to check the IRS rules to see if you qualify . The maximum 2016 contribution for those under 50 years old is $ 5,500 , and those 55 and older $ 6,500 . Your
20 DENTON COUNTY Living Well Magazine | JANUARY / FEBRUARY 2017