College & Roth IRA
"Ten years after graduating college the average non Ivy League income is less than $35,000 annually."
Source: President's 2015 college scorecard published by the Department of Education using IRS tax data.
Roth IRAs for college? Why would anyone use a retirement account to save for education expenses when there are accounts specifically designed for that? Roth IRAs add several different education savings dimensions. Here are three of them to consider.
When a child goes to college, if they want to receive student aid, the filing of a Free Application for Federal Student Aid is pretty much a must. The form is designed to calculate what's known as the expected family contribution. The EFC is essentially the amount that Uncle Sam thinks a person should pay for their own education and is calculated, in part, based on the assets of a student and his or her parents.
When reporting assets on the FAFSA form, most assets, including 529 plans, are included in the calculation. That means that saving for a child's education in a 529 plan -- a plan expressly designed for that purpose -- could end up increasing a Client's EFC, reducing or eliminating the amount of financial aid for which they would otherwise qualify.
On the other hand, Roth IRAs (along with other retirement accounts) are not considered assets when determining a family's EFC. In addition, there's no cap to that amount, so Clients may actually be able to accumulate significant sums in Roth IRAs and still qualify for student aid for a child.
To encourage people to contribute to 529 accounts, Congress created special tax breaks. As long as 529 plan distributions are used to pay qualified higher education expenses, distributions are 100% tax free (in some states, Clients may also be entitled to a state income tax deduction). But if for some reason the funds in the 529 plan are not used for qualifying expenses, distributions can go from being tax free to being taxable, plus a 10% penalty. True, a 529 plan set up for one child's benefit can be transferred to an account for another qualifying family member, but such a person does not always exist.
For obvious reasons, Clients are encouraged to start saving for college as early as possible. But how are Clients supposed to know for sure if their 5 year old child will go to college, or whether the child might receive a scholarship? That could turn a tax efficient account into a tax nightmare. If, instead of saving money in a 529 plan, your Client had saved the same money in a Roth IRA and no longer needed those funds for education, it's an easy and tax efficient transition to use those funds in retirement, which brings us to our next point.
The primary purpose of contributing funds to a 529 plan is to enjoy tax free distributions for education purposes, but a Roth IRA often provides the exact same tax benefits. If your Client is over age 59½ at the time they take distributions from their Roth IRA and they've had any Roth IRA for five years or longer, then anything they take out of their Roth IRAs will be 100% tax and penalty free. That's true whether they use the funds for education related exp enses or for any other purpose. With more people waiting to get married and have children, it is increasingly common for education related expenses to be incurred after the five years and 59½ requirements are met.
Even if your Client is not 59½ (or has not met the five year holding period) at the time education related expenses need to be paid, they may still be able to take funds out of their Roth IRA tax and penalty free. Roth IRA contributions can be distributed at any age, and at any time, 100% tax and penalty free. So, for instance, if they contribute $5,000 per year to a Roth IRA for the next 10 years before their child goes to college (and take no distributions in the interim), they'd be able to take $50,000 tax and penalty free from their Roth IRA.
In addition to Roth IRA contributions, amounts converted to a Roth IRA may also be distributed tax and penalty free. Even if your Client is under 59½, Roth IRA conversions can be withdrawn tax and penalty free as long as the conversion took place five years ago or longer.
Ed Slott * Investment News July 26, 2015