Dear Dr. Don,
I read an article regarding using a Roth individual retirement account to finance a kid’s college expenses. I have a 401(k), which I consider my main retirement savings. My oldest kid is in first grade and I am 46 years old. Is starting a Roth IRA a good idea for saving for my kid’s college education considering I will be close to 59½ years old (when my child starts college), avoiding the tax implications?
If not, what is the best tool considering we are not sure where our kids will go to college?
— Bruce Baccalaureate
I’d recommend a Section 529 plan over the Roth IRA if you expect financial aid to play a role in paying for their degrees. A 529 plan is also a good choice if your state offers a tax break for contributing to a 529 plan. One concern with 529 plans is you have to be comfortable with the investment choices and the annual fees and expenses for the account.
Section 529 plans come in two flavors: college savings plans and prepaid tuition plans. Not knowing where your child may attend college isn’t a reason to avoid a college savings plan, but it can be a reason to avoid a prepaid tuition plan.
Early distributions from a Roth IRA prior to age 59½ are not subject to the 10 percent penalty tax if they are used to finance adjusted qualified higher education expenses, or AQHEE, and the account has been established and funded for at least five years. Since it should be a dozen years before Junior is college-bound, you will meet the second hurdle. The government makes you adjust the qualified college expenses downward for any scholarships, tax credits and other items that reduce the cost of college to your student.
Contributions into a Roth IRA are made with after-tax dollars. If the early distributions for AQHEE come from contributions, there is no income-tax impact. However, if the early distributions come from investment earnings, the earnings are subject to income taxes. If you’re funding this account over the next decade, you should be able to finesse this issue by waiting to take investment earnings as distributions until after age 59½.
In making this choice, you also need to be aware of how this affects the possible need for financial aid. While the Roth IRA balance isn’t considered in calculating financial aid, there is still the issue of how the distributions affect financial aid. Even though the distributions from a Roth IRA for AQHEE may not be taxable, they’re still considered in the financial aid picture as untaxed income, reducing the need for financial aid.
That’s in contrast to the distributions from a 529 plan in which the account owner is the parent. If the parent is the account holder, the balances held are considered parental assets versus student assets, which lessen the impact on financial aid. And distributions out of the account for AQHEE are not considered income in calculating financial aid on the Free Application for Federal Student Aid, or FAFSA, form. However, individual universities may consider the 529 plan balances in their determination of financial aid.
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