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.
So, each type of saving account has advantages and disadvantages when deciding which is the best way to save for college. The Roth IRA may be better when there is some uncertainty whether the student will go to college. Otherwise, a 529 plan is better.
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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.