Roth IRAs as a Source of College Funds

By Rob Stone—Bullseye’s Investment Advisor in Louisville

Roth IRAs have been around for a little over 20 years and are more popular now than ever.  Two things are fueling this.  The first is historically low current income tax rates.  The second is the very real risk of escalating tax rates.  Concern about the public demand for more and more government-subsidized services makes us wonder what the tax rates will be when we retire.  Roth IRAs, of course, provide tax-free retirement income if managed correctly, dissolving this very real concern.

An oft-fielded question at Bullseye is, “What is the best way to save for my kids (or grandkids) college education?”  At Bullseye we highly recommend Coverdell Educational Savings Accounts because of our ability to choose from unlimited investments to achieve maximum returns.  We do this the same way as our client’s retirement accounts, by researching and selecting investments that we feel are the absolute best in their category.

As a side note, we find most state sponsored 529 plans have very limited choices and are historically loaded with such poor performing options that the tax advantage of using these plans are completely negated by poor results.

Despite our affinity for the Coverdell ESAs, they have their limitations.  Contributions are capped at $2000 annually per child and there are income phaseout limits for high income families.  These limitations can be dealt with by incorporating a Roth IRA as part of the plan to save for college expenses.  Because Roth IRA’s tax advantages, they can be a tax-favorable funding source above and beyond the Coverdell ESAs.  While we do not recommend anyone use the entirety of their retirement funds to subsidize college for a child, using Roth IRA assets can be part of the formula.

How?  When using Roth IRAs for qualified college expenses, original contributions can be withdrawn penalty-free prior to age 59 ½.  Roth IRAs are treated differently than a traditional IRAs, in that funds are withdrawn in a first-in first-out basis.  This means that contributions will come out before any earnings do.  While earnings and dividend growth are not eligible for penalty-free withdrawals, contributions are.  So, unless more is pulled out than was contributed, taxes and penalties will not be a problem.

There are three other very important and attractive features of using a Roth IRA to fund college education.  Firstly, in the event your child decides not to attend college, or receives a full scholarship, the money is yours to remain in your own account for an even better retirement.  (That is not true for 529 plans.¹)  Secondly, retirement funds are not considered by FAFSA in ‘Expected Family Contribution’ (EFC) calculations while performing financial aid assessments.  If you’ve yet to fill out a FAFSA, then just know that this can be critical.  Thirdly, income phaseout limits can also be circumnavigated using the ‘Back Door’ Roth Conversion process² to invest as much you would like to each year.  But even with these three key advantages, perhaps the greatest benefit, as with the Coverdells, is the lack of investment selection encumbrances enabling Bullseye to seek out and choose only high performing quality investments for you.

Worth noting is that there is a minimum 5 year investment window that must be met before any Roth funds can be withdrawn penalty-free, so start saving early.

At Bullseye, we are always ready to answer any questions you might have about investment and savings options that are best for you and your personal situation.

¹ If you want to use the funds in a 529 plan for anything other than qualified educational expenses, then you must pay a 10% penalty plus income tax on the funds.

² The ‘Back Door’ Roth Conversion Process:  Because there is no income limit on the ability to convert traditional IRAs to Roth IRAs if you qualify, this is often an ideal way to increase your Roth contributions.  This method requires a non-deductible traditional IRA contribution (usually in a new traditional IRA account opened just for this purpose).  Once the traditional IRA contribution is made, the funds can be transferred to a Roth IRA.  Please call Bullseye if you have any questions about this.