Dear Dr. Don,
I am paying off my daughter’s Perkins loan used for her college tuition. I am paying twice the amount due each month, so the balance is going down fairly fast. I am wondering if I should just make the minimum payment and open a Roth individual retirement account for her instead. Then, I could put the extra money now going toward the college debt into a retirement account for her. Please let me know your thoughts.
— Selfless Sally
Her ability to contribute to a Roth IRA is based on her earned income. If she’s got the earned income to contribute, then you can gift her the contribution up to the lesser of her earned income or the annual IRA contribution limits.
While we’re on the subject of gifting, if you’re making the loan payments, but the loan is in her name, then those payments are also considered a gift. The annual exclusion from the gift tax in 2014 is $14,000 or $28,000 for a married couple filing jointly and splitting gifts. Gifts above the annual exclusion go against the lifetime exclusion, currently $5,340,000.
The sooner someone starts putting money aside for retirement, the longer the time invested and the easier it is to reach retirement goals. Here, the problem is that you can’t control what your daughter might eventually do with the money in her Roth IRA. How’s your retirement savings? Putting her retirement ahead of your own only makes sense if you are on track yourself.
Stopping additional principal payments on the Perkins loan so you can fund a Roth IRA for her extends the time it takes to pay off her student loan. You’d allow interest expense to rise in order to invest in her Roth IRA. Would your daughter be better off? Well, sure. But my sense is that you are hurting yourself financially.
My rule of thumb regarding prepaying a loan: You must expect to earn less after tax on your investments than you pay (after taxes) on the loan. I suggest you continue to make additional principal payments on the student loan and let her handle the retirement savings. Only when you’ve paid off her loan should you consider the retirement funding option.
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