Roth IRA for College Savings

A Roth IRA isn’t necessarily the best choice for college savings. There are other types of accounts designed for this purpose: 529 accounts and Coverdell accounts. These accounts work much like Roth IRAs, allowing you to make nondeductible contributions, build up investment earnings inside the account, and eventually withdraw the money, including earnings, without paying any tax if the money is used for college expenses.

You can achieve the same results using a Roth IRA, provided that two things are true:

• The total amount you’re saving for retirement and college is within the limit of what you’re allowed to save in a Roth IRA, and
• The total amount you’ll withdraw before meeting the requirements for qualifying Roth IRA distributions is no more than the total amount of your contributions (in other words, you won’t dip into the account’s earnings to pay for college expenses).

When these conditions don’t exist, you’re likely to be better off using a 529 or Coverdell account for college savings. You’ll be hurting yourself on the front end (not saving enough because of the limit) or on the back end (paying tax on earnings withdrawn before retirement). If your situation happens to fit those two requirements, though, a Roth IRA can be a good place for college savings. In some situations it may work out better than if you used a 529 or Coverdell account.

The biggest advantage for the Roth IRA comes if you don’t end up using the money for college. Your child may end up not going to college, or may earn a scholarship that eliminates the need to tap your savings. In this event you’ll lose at least some of the tax benefits of saving in a 529 or Coverdell account. If you put this money into a Roth IRA, you can simply leave it there as part of your retirement savings.

Meanwhile, if you do use money from your Roth IRA for your child’s college expenses, you can still leave investment earnings in the account to be withdrawn tax-free at a later time.

Another possibility: an emergency of some sort requires you to tap money that was set aside for college. You may feel that this money is sacred and should never be used for any other purpose. Life holds surprises, though, and you could find yourself in a situation where pulling money from the college savings account is the lesser of two evils. In this situation, the rule allowing tax-free withdrawals of contributions from a Roth IRA can ease the pain. With a 529 or Coverdell account, you have to treat part of your withdrawal as taxable investment earnings, even before you’ve taken out all your contributions.

There are a number of other considerations, some favoring the Roth IRA and some favoring 529 or Coverdell accounts. Depending on where you live, you may receive a state income tax benefit when you contribute to the state’s 529 plan. Yet the investment opportunities in your state’s 529 plan may not be as good as those you can find for your Roth IRA. Using a 529 or Coverdell account will allow you to use the account’s investment earnings tax-free for college expenses. To avoid paying tax on the Roth IRA’s investment earnings you’ll have to leave them in the account until you meet the requirements for a qualified distribution.

Money in a Roth IRA doesn’t count as parental assets under the federal formula for student financial aid, but some schools use a different formula that may count this money. What’s more, withdrawals from a Roth IRA may count as income in the formula even though they don’t count as income on your tax return.

You can learn more about Coverdell accounts in our free online Guide to Coverdell Accounts.