When you’re saving for a child’s future college expenses, a 529 plan or education savings account (ESA) can be great options. But it’s important to look at other flexible alternatives, like a Roth IRA, too.
Traditional education savings accounts are excellent if the child in your life ends up going to college. But what if they don’t?
The child might want the money to buy their first home, pay for medical expenses, or spend on other things instead of attending college.
In some ways, a Roth IRA is more flexible than a 529 plan. You can choose to use a Roth IRA to pay for college, but it offers other options as well.
This article will teach you what a Roth IRA is, how you can use it to pay for college, and how it compares to more conventional ways to save for college, like a 529 plan.
What is a Roth IRA?
A Roth IRA is one form of an individual retirement account (IRA).
It differs from a traditional IRA in terms of when you get taxed.
With a traditional IRA, you can contribute either pre-tax or after-tax dollars to your account.
Your investments grow tax-deferred, and you can start withdrawing your money after age 59 ½ without paying penalties. Withdrawals from a traditional IRA are taxed as current income when you take them out.
With a Roth IRA, you can only contribute after-tax dollars. Your money also grows tax-free in a Roth IRA, just like a traditional IRA.
The difference is that you can make penalty-free and tax-free withdrawals after age 59 ½.
There are also some circumstances where you can withdraw money from a Roth IRA before age 59 ½ without paying penalties — like for college — that we will dive into in a minute.
Can a Roth IRA Be Used to Pay For College?
You might be wondering what a Roth IRA has to do with paying for college. The idea of using retirement savings to pay for college can definitely sound strange at first.
The truth is, both a Roth IRA and a 529 plan (a tax-advantaged college savings account) can provide similar benefits.
Both are tax-deferred accounts, and both can be used as an investment vehicle for college savings.
Can I use a Roth IRA for college without penalty?
Normally, you have to pay a 10% penalty when you withdraw money from a Roth IRA prematurely (before age 59 ½).
The main criteria to know about to avoid penalties is the “five-year rule.”
This states that at least five tax years must have passed since you originally opened and funded the Roth IRA before you can withdraw without penalty.
The five-year period starts on the first day of the tax year that you’ve contributed to a Roth IRA.
So if you’re planning to use a Roth IRA to help pay for a child’s college expenses, you’ll want to open one at least five years before the child will be going to college.
As long as it’s been five years since your first contribution, you can withdraw your Roth IRA contributions penalty-free whenever you want.
That’s because your Roth IRA is funded with after-tax money, so you’ve already paid tax on that income.
Let’s look at a quick example:
If you opened a Roth IRA in July 2021, then your five year period is 2021 – 2025. So, if your child goes to college in 2026 or later, you can take out your contributions penalty-free.
Keep in mind, this isn’t the case for unearned income.
So, if you invested $500 a month for five years, your contributions total $30,000.
Now, thanks to interest and/or stock market growth (depending on how the money is invested), you could have quite a bit more than that sitting in the account. But any amount over what you contributed will be penalized if you withdraw it early.
Can I use a Roth IRA for college without paying tax?
Anybody can withdraw from a Roth IRA to pay for qualified education expenses without paying tax, even if they’re younger than 59 ½.
Qualified higher-education expenses include:
- Equipment required for enrollment
- Room and board (if the individual is at least a half-time student)
If you withdraw some money to pay for non-qualified college expenses like meals or transportation, then you may need to pay some taxes.
The money contributed to the account is after-tax, so you already paid the taxes on it when it went into your Roth IRA account. But any earnings made in the account can be taxed if you withdraw them for non-qualified expenses.
For example, if you contributed $30,000 and the balance in the account is now $37,000, you have $7,000 of earnings. If this money is withdrawn to spend on things like buying your child a new car for college, you’ll pay taxes on it — assuming you’re under 59 ½.
Can parents create a custodial Roth IRA?
It’s generally not worth considering a custodial Roth IRA unless you’re holding the money for a minor with an earned income of $6,000 per year or more.
Yes, parents can create a custodial Roth IRA account for a child. However, contributions are limited to either the beneficiary’s earned income or $6,000 per year, whichever is lower.
Most kids won’t be earning any income until they get a part-time job in high school or college.
That means the contribution limit will usually be very low, if not $0.
So generally, it’s best for parents to fund a college education using their own Roth IRA or another type of investment account, rather than opening an account for a child.
The limit on total contributions toward a Roth IRA is also from all sources, not per contributor.
So relying on a custodial Roth IRA can make it nearly impossible to save up for a six-figure college expense.
Should I Get a Roth IRA as a College Student?
Funding a Roth IRA can be a great way to secure your future, regardless of your age. Most college students probably aren’t earning enough income to warrant it, though.
If you have a part-time or summer job while in college, it’s likely best to set that money aside for paying off student loans or other debts first. Prioritizing debt payments first can reduce or eliminate the interest that you’ll need to pay.
Opening a Roth IRA makes sense if someone's already covering all of your college costs or you’re on a full scholarship and don’t have any debts of your own.
You can consider contributing up to $6,000 of earned income per year into a Roth IRA if you have money that will just be sitting in savings otherwise.
Contributing to a Roth IRA won't affect your financial aid calculation on the FAFSA.
That’s because it’s a retirement account, and the FAFSA calculation only looks at education savings accounts like a 529 plan or Coverdell ESA.
Roth IRA vs. 529 Plans: How Do They Compare?
We mentioned earlier that 529 savings plans and Roth IRAs are both tax-advantaged options that you can use to save for college.
Let’s take a more in-depth look at how these two plans compare.
A Roth IRA is typically your money, in your name (unless you open a custodial Roth IRA account), so you can use it to pay for the expenses of multiple different students.
A Roth IRA is also more flexible because any money you don’t use can pay for your retirement.
A 529 plan can only have one beneficiary at a time, although you can switch the beneficiary if necessary.
Winner: Roth IRA
Income tax benefits
A Roth IRA is funded with after-tax money, so there’s no immediate tax advantage to contributing. A 529 plan is tax-advantaged at the state level.
Winner: 529 plan
You can contribute a maximum of $6,000 per year to a Roth IRA.
529 plans have a higher contribution limit. As long as you contribute less than $15,000 per year, you don’t even have to file a gift tax return.
Grandparents, other relatives, and loved ones can also front-load a 529 plan and make a one-time contribution of up to $75,000 (five year’s worth of contributions in one tax year).
Winner: 529 plan
Most 529 plans offer a limited number of investment options to choose from.
Roth IRAs provide a much wider selection — including stocks, bonds, ETFs, CDs, REITs, and mutual funds.
Winner: Roth IRA
Overall — Roth IRA vs. 529 plan
As you can see, it’s pretty much a mixed bag. Both a Roth IRA and 529 plan have their own unique advantages and disadvantages when it comes to saving for college.
For some families, the $6,000-per-year contribution limit may be a deal-breaker when it comes to Roth IRAs. It depends on your personal financial situation as to which is better.
For many families, using both options to save for college may be the best scenario.
Of course, 529 plans and Roth IRAs aren’t your only options.
Custodial Accounts: A Flexible Alternative to a Roth IRA or 529 Plan
A custodial account is a savings account that’s set up by an adult and administered for a minor until they reach legal age (18 or 21, depending on the state).
Earlier on, we mentioned qualifying education expenses. These are something that you’ll need to deal with whether you’re funding college with a Roth IRA or a 529 plan.
When taking money out of a 529 plan or Roth IRA, you may end up paying taxes and penalties if the money is used to pay for anything other than qualifying expenses like tuition or books.
A custodial account doesn’t have this limitation. Once a child is old enough, they can withdraw the money tax-free and penalty-free for whatever they want.
That makes setting up a custodial account like a UGMA (Uniform Gifts to Minors Act) account a great option to help a student pay for non-qualified expenses like a car.
EarlyBird offers custodial accounts that make it easy to invest in the financial future of the children in your life.
Start Saving For College Today
There are many different kinds of tax-advantaged accounts that you can use to pay for a college education.
Most people know about 529 plans and Coverdell ESAs but don’t realize they can also use a Roth IRA to pay for college. Depending on your circumstances, it’s another option that’s worth considering.
It’s also worth having a custodial account like what EarlyBird offers for the child in your life. You can use these kinds of accounts to pay for any kind of expenses without penalties, and sometimes even without paying taxes.
EarlyBird is the simplest way to invest in the financial future of the children in your life. Download the app and set up an investment account for a child in just a couple of minutes.
This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.