Good news – Junior is heading off to college! Bad news – college costs are higher than ever.
Fortunately, there are great ways to save for college such as 529 plans and Roth IRAs. 529 plans provide tax free growth when the funds are used for qualified education costs. Many states offer a state tax deduction for contributions into a 529 account.
Using a Roth IRA to pay for college is another overlooked option. Funded by after tax contributions, the Roth IRA is a great way to pay for college AND/OR for retirement if not needed for college. This flexibility makes the Roth IRA a handy tool for those parents who want to help with college costs, but are conflicted if their own retirement is not completely secure.
The IRS allows for contributions to a Roth IRA be used for education expenses without tax even if the taxpayer is under age 59 ½. The one requirement is that the account has to have been open for at least 5 years. The IRS treats withdrawals first as a “return of principal” and second, as interest on the investment. For those over 59 ½ who have had the Roth for more than 5 years, any amount, principal or interest, may be used for any purpose without any tax consequences.
For example, assume David is 50 years old and contributes $5,000 year to a Roth IRA for the next 5 years. At age 55, he can withdraw up to $25,000 and use it toward educational expenses without any taxes or penalties. If Jim waits until he is 59 ½ or older, he can withdraw any amount, including interest, for any reason.
The Roth IRA does have its disadvantages. These have to do with contribution limits. In order to make a contribution, you must have “earned” income. This makes it impossible for retired folks to make contributions. Also, tax payers with high incomes are prohibited from contributing to a Roth IRA. For 2017, the income limit for a single filer is $118,000 and for a joint filer $186,000.
Although 529 accounts continue to be a great planning tool, take advantage if you can, of the additional flexibility a Roth IRA account provides.