Building on the series of articles written about the advantages and practical uses of the after-tax dollars in your 401(k) or savings plan, today we explore an often-overlooked feature of the Roth IRA; higher education expenses.
As the article will describe, funding higher education expenses with a Roth IRA is a strategy only applicable to people who have a unique set of circumstances as well as a few key prerequisites. The circumstances beneath which one might consider using funds from a Roth IRA for higher education expenses would be if there is significant and reasonable doubt as to whether or not the beneficiary in question will attend college, you have no reasonable replacement beneficiary and you want to maintain control of the assets. As we cover later, this strategy should only be employed by people who have their retirement needs covered with or without the money to be used from the Roth and who are not going to rely on financial aid in concert with their contributions. This article is not intended to be a recommendation, but rather an additional option to consider for those who meet the above profile.
There are many vehicles one can use to diligently save and invest with the hopes of sending one or more children to college. The most common investment vehicles are 529 accounts, Coverdell accounts and UGMA/UTMA accounts. Now, while these savings vehicles are frequently a great fit for many investors, certain situations may give some clients pause when looking at the features of the above options.
Let us consider the 529 account:
Advantages
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Possible state income tax deduction
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No AGI phase-out for contributions
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The account owner controls the assets
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Can change the beneficiary at anytime
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Contributor can remove assets from their gross estate
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Any appreciation is tax-free if used for qualified educational expenses
Disadvantages
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There is a 10% penalty on the earnings, and the earnings are included in gross income (taxable at ordinary income rates) if not used for qualified educational expenses.
All things considered, the 529 is a fantastic option if you are assured the child you are saving for is intent on pursuing higher education. What if Robbie seems to be on a life trajectory that doesn’t include college? Of course you can transfer the accounts to your siblings’ kids or other qualified beneficiaries, but maybe you don’t have any other immediate or extended family that will require your assistance. You begin to wonder if you have another tax efficient way to save, without the looming penalty if the funds are, for whatever reason, not used for higher education.
This is where funding higher education expenses with a Roth IRA offers some investors more flexibility while maintaining tax deferred efficiency. If you find yourself unable to fund a Roth IRA due to the income phase out, please read the prior articles covering the mechanics and uses of the after-tax balance in your 401(k). High income earners may find Roth funding attractive because of the tax-deferred nature of the growth, as well as the ability to take distributions without adding any ordinary income after age 59.5.
The answer has a few nuances, but these typically build on top of the usual Roth IRA rules.
Situation 1: The withdrawals are purely return of principal. Owners of Roth accounts can take their contributions out at any time for any reason. This applies to funds that have been deposited over time and funds rolled from a qualified plan. The five year waiting period does not apply to return of principal withdrawals. This can be crucial if college funding occurs later than expected.
Situation 2: The withdrawal is partially returned principal and partially earnings. This is where qualified educational expenses matter. Any portion of a withdrawal from a Roth that is considered to be earnings, if withdrawn within five years of the initial contribution to the account or if you are under the age of 59.5, will be subject to a 10% penalty as well as taxable at your ordinary income rate. However, if those earnings are used for qualified educational expenses, you will not be subject to the 10% penalty. You will only owe taxes on the earnings portion at your ordinary income rate. This is similar to having access to a traditional IRA after the age of 59.5.
To shed a little bit more clarity on the situation, let us look at this hypothetical Roth IRA:
Hypothetical ROTH IRA for the parent of Robbie | Contibutions = 100k and Earnings = 150k |