I’ve been running this website since my kids were babies. I spent several years of their early childhood as a financial planner and constantly counseled parents to save money for a child’s education in a 529 plan college savings plan. (Here is how to open a 529 plan in Colorado step by step.) But, now, with one of the kiddos starting to look at colleges, I’m moving on from theory to the real world, and I think some changes need to be made.
Alright, let’s start with the basics. First, if you care about financial planning or planning for financial independence, you should really be reading my Finance Gourmet website where I focus on personal financial planning.
However, if you are thinking, “No way, Jose, I’m not reading about personal money and finance,” then I’ll try to take care of you with a few paragraphs on the basics of Roth IRAs, financial planning, education planning, and even a smidge of retirement planning.
What Is a Roth IRA?
All right, what is a Roth IRA after all?
A Roth IRA is one of several retirement savings accounts. What makes the Roth IRA special is that you do not get any tax benefit for making contributions to a Roth IRA. That may sound like a bad thing, but in exchange you can withdraw those contributions at any time, for any reason, without taxes or penalties, because you already paid tax on that money.
To make things crystal clear, let’s go over it piece by piece.
What Are Roth IRA Contributions?
Your contributions are the money you put into the Roth IRA. That money will grow inside of the account tax-free. The money you EARN inside the Roth IRA, whether it is interest, capital gains, or anything else is considered the earnings. Let’s do an example.
If you contribute $5,000 to a Roth IRA and put it in an S&P 500 ETF. You have contributed $5,000. That is your contributions. That number will never change unless you add more money into the account.
In the meantime, if your S&P ETF earns 20%, your account balance will be $6,000. That $1,000 is earnings. Over time, the earnings may be much larger than your contributions. No matter how much money you have in the Roth IRA, only the amount you put in counts as a contribution. Everything else is earnings.
Why am I belaboring this point?
Because, understanding the difference between contributions and earnings is crucial to understanding how to use a Roth IRA for college savings instead of a 529 plan.
Withdrawing Money From Roth IRA for College Expenses
Alright, a key feature of using a Roth IRA for college planning is that you can withdraw your contributions to a Roth IRA at any time. Any time means any time. The five-year rule does not apply. You don’t need a special reason, or any reason at all to withdraw your own contributions to a Roth IRA. Reread the above if you aren’t sure what the contributions are.
For easy math, let’s assume that you put $2,000 each year into a Roth IRA for 10 years while your kiddo is growing up. Now, let’s say it earned 8% per year for those 10 years, you end up with around $31,000 in the account. If you were paying attention so far, you know that this means there are $20,000 in contributions (10 years x $2,000), and $11,000 in earnings ($31,000 total – $20,000 contributions).
You can withdraw that $20,000 at any time for any reason. (Don’t be a fool, though.)
There are all kinds of rules about that $11,000 in earnings.
So, obviously, you could use the $20,000 for college.
What about the $11,000? Well, like I said there are rules, but one of the reasons you can withdraw that $11,000 is for college expenses. If you want details on that, you need to read my using Roth IRA for college savings article on FinanceGourmet where I go into more detail on this.
Why You Should Use Your Roth IRA for College Savings
Alright, now here is the deal that comes from some real-world knowledge. When colleges determine your eligibility they look at four things: your income and your assets, and your kid’s income and your kid’s assets. Your kid’s assets count against you way more than parent’s assets, so never save money in your kid’s name.
Most schools count a 529 plan as parent’s assets, so it is better to save in a 529 plan than in your kid’s name. Plus, the money grows tax-free, just like a Roth IRA.
Here is the kicker, the money in your Roth IRA DOES NOT count as assets. None of your retirement accounts whether a 401(k), a Roth IRA, a regular IRA, an annuity, or a pension, counts against you. Also, life insurance balances do not count against you either.
So, $25,000 in a Roth IRA counts as zero assets for determining need-based financial aid, but a $25,000 529 plan counts as $25,000 in parents’ assets.
Again, for more details, hit up my Finance Gourmet articles.
Why You Should Not Use a Roth IRA for College Savings
Believe it or not, you are going to need WAY more money for retirement than paying for your child’s education, and there is no such thing as retirement loans like there are student loans. So, if you need your Roth IRA for retirement savings, then prioritize that, and use a 529 plan for your child’s college savings.
However, if you aren’t maxing out your 401(k) plan, then you have somewhere else for those retirement savings. Even if you are maxing out your 401(k) plan, there is always the option to use only the contributions for college and leave your Roth IRA earnings in the account.
Again, more details if it is smart to use a Roth IRA for college on my Finance Gourmet page.