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The Short Answer

Can I Use a Roth IRA to Pay for College?

Here are the pros and cons of using Roth IRAs for college savings.

Question: Can I just use a Roth IRA for college savings and not worry about opening a 529? If my child doesn't go to college, I can use the Roth IRA as extra retirement savings.

Answer:  It’s true that you can use a Roth IRA for college expenses, but it’s better suited as a retirement savings vehicle. Retirement is filled with uncertainty--we don’t know how long we'll live or whether we'll be in good health. A well-fed retirement account is the best way to hedge these risks.

If you decide to save money for college, it’s better to be deliberate about it and not let it seep into and potentially derail your retirement savings. 529s, though not perfect, are the better fit for dedicated college savings in my opinion.

I’ll lay out some facts about Roth IRAs as compared with 529s that might help you choose.

The Big Picture
529s and Roth IRAs are both funded with aftertax dollars and offer tax-free growth (when you make qualified withdrawals). One of the first questions you should consider is whether or not your state offers a tax benefit for contributing to a 529 (if so, one point in favor of using 529s for college savings).

It's true, however, that Roth IRAs give you more freedom when it comes to investment selection--with 529s you're limited to a menu of choices. (I'll score this in favor of the Roth IRA, but with the caveat that many 529 plans offer low-cost investments that are sensibly allocated and professionally rebalanced, which I consider a benefit.) 

How Are Roth IRA Withdrawals Taxed?
If you withdraw earnings from a Roth IRA before you’re 59 1/2 (or even if you ARE 59 1/2 or older but you haven’t held the account for five years including conversions), you will pay taxes at your ordinary income tax rate and you will pay a 10% early withdrawal penalty.

Qualified education expenses are an exception to the early withdrawal penalty. If you use a Roth IRA withdrawal for qualified education expenses, you will avoid the 10% penalty, but you will still pay income tax on the earnings portion. Many people are surprised to hear this, but remember that your Roth IRA account balance is made up of contributions and earnings. You can always withdraw the contributions tax-free and penalty-free at any time, for any reason, because you have already paid tax on that income. Not so for the earnings portion.

How Are 529 Withdrawals Taxed?
A 529 is also funded using aftertax dollars, but both the contributions and earnings are tax-free and penalty-free when used for qualified education expenses. 

If you withdraw money from a 529 and don’t use it for qualified education expenses, you will pay ordinary income tax and a 10% penalty on the earnings portion. But unlike with a Roth, 529 distributions are pro-rata--it’s not possible to withdraw only the contributions unless the account has no earnings at all.

How Much Can You Contribute to a Roth?
The yearly maximum contribution is $6,000 ($7,000 if you’re over 50).

You can contribute the full amount only if your modified adjusted gross income is below $122,000 for single filers (partial contribution up to $137,000). If you’re married filing jointly with a MAGI less than $193,000 you can make the maximum contribution (up to $203,000 for a partial contribution). Savers of any income level can also convert a Traditional IRA to a Roth IRA in a taxable event known as a “backdoor” conversion.

How Much Can You Contribute to a 529?
You can contribute up to $15,000 per year, per 529 account, without incurring federal gift tax. You can also “superfund” the account by making a contribution of up to $75,000 (or up to $150,000 for a married couple), then electing to treat the contribution as having been made over a five-calendar-year period for tax purposes.

There are no income limits for contributors.

How Do Roth IRA Assets Affect Financial Aid?
Roth IRA assets, as well as other qualified retirement accounts such as traditional IRAs or 401(k)s, are not counted at all in determining the expected family contribution that determines how much financial aid you are eligible to receive. (A higher expected family contribution means less financial aid; the expected family contribution is calculated using information reported on the Free Application for Federal Student Aid.)

If you use money from a retirement account to pay for college, though, it will affect your expected family contribution two years after you use it. That’s because eventually the entire withdrawal shows up as income on the FAFSA form and counts at a 20%-50% rate--even the tax-free return of contributions, which shows up as untaxed income.

To minimize the impact, don’t use a Roth IRA distribution to pay for college until the student has filled out the FAFSA for the second year of college.

How Do 529 Assets Affect Financial Aid?
529 assets that are owned by the parent or the student are counted at a 5.64% rate when determining financial aid eligibility. Qualified distributions from a parent- or student-owned 529 are ignored, meaning they do not count as income for expected family contribution purposes. 

One potential pitfall is when the 529 account is owned by someone other than the student or parent, such as grandparents. In this case, the distribution will be counted as untaxed income on the FAFSA, which can count at a 20%-50% rate. To minimize the impact, don’t use a distribution from a grandparent-owned 529 to pay for college until the student has filled out the FAFSA for the second year of college.