When it comes to college savings most people have heard about 529 plans, savings bonds, and custodial accounts. However, there is another player in the game that many overlook that provides a dual-purpose investment option. Custodial Roth accounts, known for their post-tax investment growth for retirement, can also have a place in the college savings plan.
When saving for your child, grandchild, or other loved one’s college it goes without saying that you want to be able to provide the optimal amount of support with the funds you save. However, often the beneficiary of those savings may choose not to attend college for one reason or another. When considering the risk of the child not attending college one might consider options with both the flexibility of use and attractive tax benefits. For these reasons, many may turn to a Roth IRA for the benefit of their loved one’s future.
As many may already know, Roth IRAs provide tax-free growth on investments as long as the parameters are met of a qualified distribution. If the distribution does not meet the qualified requirements part of it may be included in the owner’s gross income and be subject to an additional 10% tax penalty. Two of those exceptions are for distributions used toward a first-time home purchase and qualified higher education expenses. Both exceptions complete what we will call the triple threat (college, first home, and retirement). The triple threat is an attractive kick-start to any young person’s financial future. For the sake of this writing, we will focus on qualified higher education expenses.
The qualified higher education expense exception allows the Roth IRA owner to withdraw contributions, both tax, and penalty-free. However, were the college expenses to require the owner to tap into any earnings of the funds invested in the account, they would be subject to income tax but still, avoid the 10% penalty.
Pat’s daughter Dakota started babysitting at the age of 12 and in the summers, she cleans her parents’ office. Dakota loves music and potentially may forgo college to pursue a career in music. Pat doesn’t want to invest money into an investment vehicle like a 529 and pressure his daughter into having to use it toward college. He wants to invest in her future financial freedom in a way that will support her if she chooses to go the music route. So, Pat contributes $6,000 every year from Dakota’s age 12 to 18. After a year of traveling and playing across the country, Dakota decides she wants to go to college to earn a music degree. When Dakota begins college at the age of 20 the $42,000 of contributions has grown to $75,000. Dakota can now use $42,000 toward her college education tax and penalty-free and can also use the $33,000 of earnings penalty-free but would owe income taxes on this portion. Preferably, Dakota could use the $42,000 of contributions to fund college and allow the remaining $33,000 to continue growing tax-free toward her retirement!
Do you feel the Roth college savings strategy is right for you? Here are a few things to consider as you put your plan into action.
- FAFSA eligibility. Roth accounts are not reported as an asset when applying for financial aid, however, the tax-free withdrawal of contributions will count toward untaxed income. Consider timing and the most tax advantageous way of taking distributions to optimize the aid needed.
- 5-year rule. Roth assets must be held for at least 5 years before they are eligible for any penalty-free distribution.
- Ensure the contributions made to the Roth account meet the lesser of the owner’s earned income or the annual IRA allowable amount.
- Distributions above the account’s contribution basis will be subject to income tax if used for qualified education expenses – but will avoid the 10% early distribution penalty.
- IRS ordering rules of Roth IRA distributions above the contribution amount.
- Consider using the IRS tool “is the distribution from my Roth account taxable?”
As with most financial decisions you will want to consider the options available to you and ensure that your personal goals align with this financial planning strategy. We recommend consulting with a financial advisor to ensure the strategy is right for you.
If you’re looking for a trusted CERTIFIED FINANCIAL PLANNER™ professional whose fiduciary duty is to you and your wealth only, call Tull Financial Group today at 757.436.1122 to see how we can help you plan for your loved one’s future!