If you have children or grandchildren whom you hope will go beyond high school and receive a college education, there’s a good chance you’ve thought about setting some money aside to help pay their expenses.

There are some terrific ways to do this, including utilizing 529 plans, but one savings vehicle that is often overlooked as a way to fund a child’s college education is a Roth individual retirement account.

Most people think of the Roth IRA as a terrific method to save for retirement—which it is—but it can also be a great tool to help you cover Junior’s university tab.

Unlike 529 plans, which can be used only to cover the costs associated with college, Roth IRAs can be used for both college expenses and retirement income. Let’s see how you can do this and benefit from it.

• Is a Roth IRA a good way to Save for College?
• Advantages and Disadvantages of Roth IRA for College
• Can I use Roth IRA for College Without Penalty?
• Is Roth IRA Better than 529?
• Can I Convert my Roth IRA to a 529?
• What is the 5 year rule for Roth IRA?

Is a Roth IRA a good way to Save for College?

You may know the Roth IRA as a retirement vehicle, but you can also use it to save for college. You can contribute to a Roth IRA at any age, as long as you have “earned income” (taxable income) and don’t make too much money.

Read Also: Should you Convert your Traditional IRA or 401(k) to a Roth IRA?

Unlike traditional IRAs, there are no required minimum distributions (RMDs) with Roth IRAs during your lifetime. That means you can keep your money in the account if you don’t need it.

Given how good a Roth IRA is for retirement savings, does it make sense to use it to fund college? Let’s look at some of the advantages and disadvantages.

Advantages and Disadvantages of Roth IRA for College

Advantages

Many of the advantages that make a Roth IRA a great way to save for retirement make it an ideal way to save for college, too.

Like the 529, there is no income tax deduction when you contribute to a Roth IRA. Instead, your contributions and earnings grow tax-free. And because you’ve already paid your taxes, you can withdraw contributions at any time, for any reason, tax-free.

Many families use money from a Roth IRA to pay for at least a portion of their children’s college expenses. The real magic of the Roth IRA happens if you waited until later in life to have kids or you’re saving for grandkids.

Once you reach 59½ (and it’s been at least five years since you first contributed to a Roth), all of your withdrawals—earnings as well as contributions—are tax-free. That means 100% of your withdrawals can go to college expenses.

If you’re not 59½ yet, withdrawals of earnings will be subject to income taxes, but not an early withdrawal penalty, as long as the cash is used for college expenses.

What’s more, any money you don’t end up spending on college can remain in the Roth to fund your own retirement.

Disadvantages

First, the annual contribution limit is low. For 2021 and 2020, you can contribute $6,000, or $7,000 if you’re age 50 or older. That means that over the course of 18 years, you could add up to $108,000, or $216,000 if you and your spouse both contribute to an IRA.

Generally speaking, both of you would have to contribute the full amount to fund a child’s college education on contributions alone.

Second, unlike some 529 plans, there’s no state income tax deduction for Roth IRAs.

Third, money that’s inside a Roth isn’t counted for financial aid purposes. However, withdrawals are counted, and that can affect your financial aid package. That’s because withdrawals are counted as income, even though the money isn’t taxed.

Finally, by using a retirement account for college savings, you lower the amount of money you can save for your own retirement. If using a Roth to save for college impacts your retirement savings because you bump up against annual contribution limits, it might be better to use the 529.

Ideally you want to save for retirement and college, but if you can only afford to save for one, retirement is generally preferred. The rule of thumb in financial services is, “You can borrow for college, but not retirement.”

But it’s not always a bad idea to use retirement assets for college depending on your tax bracket, income, assets, state of residence, liquidity, and other factors.

In some cases you may want to make college savings a priority. If you live in Indiana, for example, residents have access to a state tax credit of 20% on contributions up to $5,000 into one of the state’s 529 plans, resulting in up to a $1,000 tax credit.

This is a straight $1,000 reduction on the actual amount of tax owed. Therefore, Indiana residents have a greater incentive to save for college.

Generally, if you can, save for both. If not, carefully consider your unique financial situation before deciding which combination of vehicles to use. And if this is all just too overwhelming, seek the help of a financial professional.

Can I use Roth IRA for College Without Penalty?

While it won’t generally be suitable as your only method, it can offer several advantages. But can you Roth IRA for college without penalties? Here is why the answer is YES.

1. Unlike a 529 plan, if your child doesn’t end up needing the money for college, you won’t incur a penalty to use it for something else. If you want to withdraw money from a 529 to use for a non-education related expense, you’ll be charged a 10% penalty.
2. You can withdraw your Roth IRA contributions at any time without penalty or tax for any reason. You can also withdraw earnings without the 10% penalty if they’ll be used to pay for qualified education expenses. You will have to pay tax on those earnings if you choose to withdraw them, so you may want to leave them in the account for your own retirement. Roth IRA earnings are only tax-free if withdrawn after 59 1/2, even if used for education expenses (i.e. tax implications of retirement accounts).
3. If you contribute to a Roth IRA and qualify for the Saver’s Credit, you could get a break on your taxes. On the other hand, contributions to a 529 plan or other college savings plans are not eligible for this credit.
4. It’s important to consider the effect your savings will have on your child’s eligibility for financial aid. In general, parental ownership of and withdrawals from a Roth IRA will have no impact, or minimal impact, on financial aid eligibility. 529 plans, however, regardless of ownership, will negatively affect financial aid eligibility. Who owns the 529 plan determines how extensive the impact is.

If you have a traditional IRA, you’ll owe income tax on any money that you withdraw at any time. Like the Roth IRA, the 10% penalty is waived if you use the money for educational purposes.

However, since the tax bill on withdrawals from a traditional IRA can be pretty steep, we wouldn’t recommend planning to use one to save for college. The ability to withdraw Roth contributions tax-free is what makes them a good option for college savings.

Also, when you withdraw money from a traditional IRA and have to pay taxes on it, it gets added to parental assets as income on the FAFSA. That might end up costing you a lot in financial aid, since to the school it would look like you just had a great year!

Is Roth IRA Better than 529?

When it comes to saving for college, there are two accounts that offer more tax breaks than any other: the 529 plan and the Roth IRA. Both are fantastic options, and in this article we’ll break down each one so you know whether to choose a 529 plan or Roth IRA for your college savings.

Pros of 529 Plans

A 529 plan is a dedicated college savings account that offers special tax advantages when used for college expenses.

There are two types of 529 plans: savings plans and prepaid tuition plans. For this article we’ll focus on savings plans, since those are the most common.

Here are the pros of using a 529 plan for college savings:

Tax Advantages

A 529 plan works a lot like a Roth IRA — it’s just designed for college instead of retirement:

• There’s no deduction for contributions (though we’ll discuss some exceptions below).
• Money grows tax-free while inside the account.
• Money can be withdrawn tax-free for qualified education expenses, such as college tuition, room and board fees, or textbooks. And as of 2018, that includes up to $10,000 per year for K-12 education expenses such as private school tuition or tutoring.

Other than a Coverdell ESA, which has other limitations, no other account offers this many tax benefits for college savings.

Potential State Income Tax Deduction

In some cases you can get a state income tax deduction if you contribute to your home state’s 529 plan.

Keep in mind that you’re allowed to use a 529 plan from any state, not just your own. So whether or not your state offers an income tax deduction, you can choose to use another state’s plan if you think it’s a better option.

High Contribution Limits

There are no income limits on 529 plan contributions, so they’re available to everyone. You’re also allowed to contribute quite a lot. Most plans simply have a total contribution limit that’s usually in the $200,000 to $400,000 range.

There’s technically no annual contribution limit, though in most cases it’s a good idea to stay within the limits of the annual gift tax exclusion. For 2016, that means that each parent can contribute up to $14,000 for each child without gift tax implications. If you’re married, that means up to $28,000 per year for each child.

There’s even a rule that allows you to contribute up to five times that amount in a single year if you’d like. In other words, if you want to contribute a lot of money towards college, a 529 plan is a good way to do it.

Flexibility to Change Beneficiaries

If your child doesn’t end up needing all of the money you saved, you can use it for someone else.

You’re allowed to change the beneficiary of a 529 plan to any member of the original beneficiary’s family. Typically that would mean a brother or sister, or even you or your spouse.

So if one child doesn’t end up needing the money, there are easy ways to make sure it doesn’t go to waste.

Flexibility With Scholarships

Typically, there are taxes and penalties if you withdraw money from a 529 plan and don’t use it for college expenses (more on this just below).

But there are certain exceptions, and scholarships are one of them. If your child qualifies for a scholarship, you can withdraw up to the amount of that scholarship penalty-free.

You’ll still have to pay taxes on the earnings (any investment gains from your original contributions), but that just means you’ll have gotten tax-deferred growth in the meantime.

And in any case it’s nice to know that you won’t be penalized if your child is able to use his or her talents to pay for a college education.

Cons of 529 Plans

While 529 plans are incredibly helpful in the right situations, you shouldn’t necessarily start contributing as soon as you have children. Here are three big reasons to consider alternatives:

Penalties and Taxes If Not Used for Education

Though there are some exceptions for instances like scholarships, for the most part money within a 529 plan will be taxed and penalized if it’s withdrawn for anything other than qualified education expenses. And if you received a state income tax deduction for your contributions, you may have to pay that back as well.

This is worth considering since there are a lot potential reasons that you might want to use this money for other goals:

• Your child may go to a lower cost school than you anticipated.
• Your child may not want to go to school at all.
• The trend could reverse and college could become less expensive in the future.
• You might need money for something else in the meantime.

It’s worth noting that only the earnings in the account will be taxed and penalized. The amount you’ve contributed won’t be subject to either. But every withdrawal is counted as part contribution and part earnings, so in most cases you won’t be able to completely avoid the penalties.

Limited Investment Options

Like 401(k)s, 529 plans all offer a relatively limited lineup of investments. Depending on the plan you’re considering, that could mean that you don’t have a lot of good options.

For example, some plans are filled with expensive investments. And while cost isn’t the only factor to consider, it is the single best predictor of future investment returns and high-cost investments will be a significant obstacle to success.

The good news is that you’re allowed to choose any 529 plan offered by any state. You aren’t limited to your state’s plan and there are plenty of states that offer a strong lineup of high-quality, low-cost investments.

So in many cases the limited set of investments doesn’t have to be a big deal, but it could be an issue in the following situations:

1. You get an income tax deduction if you use your state’s plan, but your state’s plan is high cost.
2. You have a specific investment strategy you want to implement and you can’t do it within a 529 plan.

Pros of Roth IRAs for College Savings

While the Roth IRA is technically a retirement account, it has some characteristics that can also make it an effective way to save for college. In some situations, it may even be preferable to using a 529 plan.

Here are some of the benefits of using a Roth IRA for college savings.

Special Withdrawal Rule for Higher Education

Roth IRA withdrawals are 100% tax-free once you reach age 59.5, but the earnings are typically taxed and penalized if they’re withdrawn before then. Which means that in most cases you’ll want to avoid early withdrawals.

But there are some special rules that allow you to get around those penalties, especially if you’re withdrawing the money for college expenses:

1. You can withdraw up to the amount you’ve contributed without taxes or penalties at any time and for any reason. For example, if you’ve contributed $50,000 to your Roth IRA and it’s grown to $75,000, you can withdraw up to $50,000 any time you want without consequence.
2. You can withdraw the earnings penalty-free (but not tax-free) if the money is used for college expenses for you, your spouse, your children, or your grandchildren.

While this isn’t quite the same tax benefit as that offered by 529 plans, it’s still better than most other accounts.

Tax Deferral in the Meantime

Like a 529 plan, your money also grows tax-free while inside of a Roth IRA. This allows your money to grow faster than it would inside of most other accounts.

Flexibility

The biggest reason to choose a Roth IRA over a 529 plan is the flexibility you have to use the money for various purposes.

For example, it’s generally more important to save for retirement than to save for college, simply because there are many ways to pay for a college education but you have only yourself to rely on for retirement.

With a Roth IRA, you can save money now and decide later what you want to use it for. If your retirement is on track through other accounts, you can direct the money to your child’s education. If not, you can keep the money in the Roth IRA for retirement.

And even beyond that, Roth IRAs are extremely flexible accounts with many potential uses, so contributing to a Roth IRA can open up more opportunities than contributing to a 529 plan.

Not Counted as Asset for Financial Aid

Many people worry about contributing to a 529 plan because of the impact on financial aid. That worry is largely overblown, mostly because only about 5% of the money inside of a 529 plan is actually counted for financial aid purposes, and because having money is much better than needing it.

Still, a Roth IRA isn’t counted as an asset for financial aid purposes at all, and the last time we checked 0% is less than 5%. So in some situations, having your college savings in a Roth IRA may help you qualify for financial aid.

More Investment Options

Unlike 529 plans, you can invest in just about anything you want within a Roth IRA. That means that you can both minimize your investment costs and implement any investment strategy you choose.

Cons of Roth IRAs for College Savings

Roth IRAs can be a great way to save for college, both because of the tax benefits and the flexibility to use the money for whatever opportunities you and your children want to pursue. But there are some downsides as well, and here are some of the biggest.

Fewer Tax Benefits

A Roth IRA offers fewer tax benefits than a 529 plan IF the money is used for higher education.

• 529 plans allow for tax-free withdrawals of earnings, while Roth IRAs do not (at least, not until you’re age 59-1/2).
• Some states offer income tax deductions for contributions to a 529 plan. Roth IRAs never get this benefit.

If the money you’re saving does end up being used for college expenses, a 529 plan will likely save you more money.

Potential Financial Aid Trap

While the money inside of a Roth IRA is not counted toward financial aid, withdrawals from a Roth IRA are counted. And those withdrawals can have a big impact.

Most people worry that saving money will hurt their financial aid eligibility, but the reality is that your income will have a much bigger impact. According to SavingforCollege.com, only 2.6% to 5.6% of your savings is counted on the FAFSA while 22% to 47% of your income is counted.

And for financial aid purposes, 100% of withdrawals from a Roth IRA and other retirement accounts count as income, even if the money isn’t taxed as income.

For example, remember above when we said that you can withdraw up to the amount you’ve contributed to a Roth IRA at any time without tax or penalty? That’s still true, but it WILL be counted as income on your FAFSA application, which will likely hurt your child’s chances for financial aid.

One way around this is to simply wait until your child’s last year of college to withdraw money from a Roth IRA, but of course you may need the money before then. And even if you don’t, that strategy could hurt a younger child’s financial aid eligibility.

Just know that if you are applying for financial aid, you need to be very careful about withdrawing money from a Roth IRA.

Sacrificing Valuable Retirement Space

You risk sacrificing valuable retirement space when you use a Roth IRA for college savings.

If your retirement is 100% covered by other accounts, then this isn’t a big deal. But if not, be careful not to count this money as being available for both retirement and college. It can only be used for one, and when push comes to shove retirement should usually get the nod.

Smaller Contribution Limits

Unlike 529 plans, Roth IRAs have some pretty significant contribution limits. First, each person can only contribute up to $5,500 per year ($6,500 if you’re 50+). Second, there are income limits that may prevent you from contributing at all.

If you’d like to save a lot of money for college expenses, the Roth IRA likely isn’t going to cut it.

Can I Convert my Roth IRA to a 529?

You cannot roll over a traditional individual retirement account (IRA) into a 529 plan without paying taxes. The Internal Revenue Service (IRS) considers putting an IRA distribution into a 529 plan as a distribution included in your taxable ordinary income.

Beyond the income tax, you would also face an additional 10% tax penalty for the early withdrawal if you are not yet 59½ years old. After those taxes, you could contribute what’s left to the 529 plan.

Thus, funding a 529 account from a traditional IRA is not a good idea. Consider these alternatives instead.

Use an IRA Distribution to Fund Education Expenses

Rather than opening the 529, you might consider using the IRA distribution for education expenses. Withdrawals from your traditional IRA for the purposes of higher education are exempt from the 10% penalty. This exemption applies to Roth IRAs as well

Penalty-exempt expenses include “tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution,” according to the IRS. You should visit the IRS website to get a full breakdown of the exempt qualified higher education expenses.

Remember, the higher education expense would exempt you from the 10% penalty, but the distribution would still incur the ordinary income tax.

In addition, the distribution may need to be included as income on any financial aid applications, especially the Free Application for Federal Student AID (FAFSA), so be sure to time it carefully.

What is the 5 year rule for Roth IRA?

One of the much-touted boons of the Roth IRA is your ability—at least, relative to other retirement accounts—to withdraw funds from it when you wish and at the rate you wish. But when it comes to tax-advantaged vehicles, the Internal Revenue Service (IRS) never makes anything simple.

True, direct contributions to a Roth can be withdrawn anytime, without tears (or taxes). Withdrawals of other sorts of funds, however, are more restricted: Access to them is subject to a waiting period, known as the 5-year rule.

The 5-year rule applies in three situations:

• You withdraw earnings from your Roth IRA.
• You convert a traditional IRA to a Roth IRA.
• You inherit a Roth IRA.

You need to understand the 5-year rule—or rather, the trio of 5-year rules—to ensure that withdrawals from your Roth don’t trigger income taxes and tax penalties (generally, 10% of the sum taken out).

Roth IRA Withdrawal Basics

As you know, Roths are funded with after-tax contributions (meaning you get no tax deduction for making them at the time), which is why no tax is due on the money when you withdraw it.

Before reviewing the 5-year rules, here’s a quick recap of the Roth regulations regarding distributions (IRS-speak for withdrawals) in general:

1. You can always withdraw contributions from a Roth IRA with no penalty at any age.
2. At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years

A withdrawal that is tax- and penalty-free is called a qualified distribution. A withdrawal that incurs taxes or penalties is called a non-qualified distribution. Failing to understand the difference between the two and withdrawing earnings too early is one of the most common Roth IRA mistakes.

In sum, if you take distributions from your Roth IRA earnings before meeting the 5-year rule and before age 59½, be prepared to pay income taxes and a 10% penalty on your earnings. For regular account-owners, the 5-year rule applies only to Roth IRA earnings and to funds converted from a traditional IRA.

5-Year Rule for Roth IRA Withdrawals

The first Roth IRA 5-year rule is used to determine if the earnings (interest) from your Roth IRA are tax-free. To be tax-free, you must withdraw the earnings:

• On or after the date you turn 59½
• At least five tax years after the first contribution to any Roth IRA you own³

Note for multiple account-owners: The five-year clock starts with your first contribution to any Roth IRA—not necessarily the one you’re withdrawing funds from. Once you satisfy the five-year requirement for one Roth IRA, you’re done.⁴

Any subsequent Roth IRA is considered held for five years. Rollovers from one Roth IRA to another do not reset the five-year clock.

5-Year Rule for Roth IRA Conversions

The second 5-year rule determines whether the distribution of principal from the conversion of a traditional IRA or a traditional 401(k) to a Roth IRA is penalty-free.

(Remember, you’re supposed to pay taxes when you convert from the pre-tax-funded account to the Roth.) As with contributions, the 5-year rule for Roth conversions uses tax years, but the conversion must occur by Dec. 31 of the calendar year.

For instance, if you converted your traditional IRA to a Roth IRA in Nov. 2019, your five-year period begins Jan. 1, 2019. But if you did it in Feb. 2020, the five-year period begins Jan. 1, 2020. Don’t get this mixed up with the extra months’ allowance you have to make a direct contribution to your Roth.

Each conversion has its own five-year period. For instance, if you converted your traditional IRA to a Roth IRA in 2018, the five-year period for those converted assets began Jan. 1, 2018. If you later convert other traditional IRA assets to a Roth IRA in 2019, the five-year period for those assets begins Jan. 1, 2019.

It’s a bit head-spinning, admittedly. To determine whether you are affected by this 5-year rule, you need to consider whether the funds you now want to withdraw include converted assets, and if so, what year those conversions were made.

Read Also: Get a Head Start on College Savings

Try to keep this rule-of-thumb in mind: IRS ordering rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings.

If you’re under 59½ and take a distribution within five years of the conversion, you’ll pay a 10% penalty unless you qualify for an exception

Final Words

While a Roth IRA can be an excellent college savings vehicle, contributions need to be balanced with your own retirement savings. If you are using a Roth to save for college for your children, make sure you’re also saving for yourself.

This could be in a work-sponsored 401k retirement plan or also in a Roth that’s doubling as a college savings vehicle.

Examine the advantages of using a Roth IRA for retirement savings and compare these with the advantages of using one for college savings.

Consider what other retirement plans are available to you, how you feel about tax-free vs. taxable income at retirement, and how much you can annually contribute. You may end up choosing the 529 over the Roth to save for college, in spite of the Roth’s college savings advantages.

As with most financial planning, the process must be personalized to your unique situation. Preparation is key. You may want to meet with a financial advisor in order to put together a comprehensive and customized plan.