A Roth IRA can be used to pay for college, but there are some advantages and disadvantages when compared with using a 529 college savings plan to pay for college. Although a Roth IRA may offer some tax advantages, distributions from a Roth IRA can hurt eligibility for need-based financial aid.
Like a 529 plan, contributions to a Roth IRA are made with after-tax dollars, earnings accumulate on a tax-deferred basis, and qualified distributions are entirely tax-free. But, annual contributions are limited to $5,500 a year ($6,500 if age 50+) or earned income, whichever is less, and are subject to income phase-outs.
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The account owner of a Roth IRA can take a tax-free return of contributions at any time and does not have to wait until age 59-1/2. The earnings portion of a non-qualified distribution is subject to ordinary income taxes plus a 10% tax penalty, but the penalty is waived if the distribution pays for educational expenses.
However, Roth IRAs are not well designed for paying for college costs. Money in a Roth IRA is not reported as an asset on the Free Application for Federal Student Aid (FAFSA). But, a tax-free return of contributions will count as untaxed income to the beneficiary, reducing eligibility for need-based aid by as much as half of the distribution amount.
One workaround is to wait until the distribution from a Roth IRA will no longer affect aid eligibility. For example, if the student will graduate in four years, distributions after January 1 of the sophomore year in college will not affect aid eligibility, due to the FAFSA using a prior-prior year system for reporting income and tax information. But, if the student will be graduating in five years, they will need to wait until after January 1 of the junior year in college to take a distribution.
The safest approach is to wait until after the student graduates to take a tax-free return of contributions to pay down student loan debt.
A Roth IRA is a good option if the child ultimately decided to not go to college. Then, the money in the Roth IRA will give the child a head start on saving for retirement. Assuming an average annual return of 5.25% or more, every $1,000 in a Roth IRA will yield $10,000 at retirement in 45 years. The child can also choose to take a tax-free return of contributions from a Roth IRA for a down payment on a house.