Saving for your child’s college education can be done through a variety of accounts from Coverdells to 529s. Very few financial advisors, however, talk about the possibility of saving for your children’s college expenses in an educational Roth IRA.
For some people, this is an excellent way to save for these costs while still maintaining a lot of flexibility with their money. For other, however, there are better options.
What is an Educational Roth IRA?
An educational Roth IRA follows the same rule as a regular Roth IRA.
In fact, many people simply open up one account for their retirement and kids’ college education savings since tax rules limit your total contribution to all types of Roth IRAs.
If you are under 50 and make below a specified income limit (for 2010 $167,000 for married couples and $105,000 for singles) you can contribute up to $5000 a year. Those over 50 can contribute up to $6000 per year.
All contributions into a Roth IRA for education are made with after-tax dollars, but the gains made in the account as well as the withdrawals after age 59 ½ are tax-free.
For parents older than this threshold when their children got to college, simply withdrawing money out of the account to pay tuition bills could be a good option.
There are no limits on the amounts allowed for withdrawals after you reach this age threshold.
By IRS rules, however, the account must have been open for at least five years prior to starting age-related withdrawals.
Parents who qualify for and choose this way to make withdrawals should be aware that while the money does not count towards their income, any leftover money that is left in a savings or checking account will have to be reported on next year’s FAFSA.
Therefore, make sure that you only withdrawal what you plan to use within the next year.
For parents who will not reach this age by the time they will need to start paying tuition, a Roth IRA for education can still be a good savings tool.
Anyone is allowed to withdrawal their contributions at any time without paying a penalty to the IRS.
If you contribute the maximum of $5000 to a Roth IRA over the first 18 years of your child’s life, you would be able to withdrawal all $90,000 of those contributions for any purpose.
What if My Child Receives a Scholarship?
If your child receives a scholarship, but needs help with living expenses this can be an ideal way to help him or her.
Again, be careful not to withdrawal too much at one time, as any leftover money will show up as funds available to be put towards higher education costs on next year’s FAFSA.
Any gains made on the money are subject to taxation. However, if you need to use this money for qualified higher education expenses (QHEE), the IRS will waive the 10% penalty that would normally apply.
Current QHEEs include tuition, room and board, books, mandatory fees, and equipment. See IRS Publication 970 for limits on these categories. Currently, QHEEs do not include transportation costs or student loan repayments.
Therefore, plan your use of these funds very carefully.
Talk to your child’s school to make sure your Roth IRA funds get applied to these categories, and that any financial aid your child receives gets disbursed after these funds have been paid into his or her account.