If you have children or grandchildren whom you hope will go beyond high school and receive a college education, there's a good chance you've thought about setting some money aside to help pay their expenses. There are some terrific ways to do this, including utilizing 529 plans, but one savings vehicle that is often overlooked as a way to fund a child's college education is a Roth individual retirement account.
Most people think of the Roth IRA as a terrific method to save for retirement—which it is—but it can also be a great tool to help you cover Junior's university tab. Unlike 529 plans, which can be used only to cover the costs associated with college, Roth IRAs can be used for both college expenses and retirement income.
While it's true that deposits into Roth IRAs receive no tax deduction, it's also true that these accounts then grow tax-deferred. So with a little planning, they can be an ideal source for funding a loved one's higher education.
Here's why: Withdrawals from IRAs, including Roth IRAs, are actually exempt from withdrawal penalties if the funds are used specifically for qualified educational expenses, including tuition, fees, books and room and board.
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For most folks who are sending their kids off to college, only the contribution portions of their Roth IRA balances can be withdrawn tax-free. (Any earnings in the account will be taxable for those people under 59, as well as for those over 59½ who haven't held the Roth for at least five years.)
But Roth IRAs enjoy a rather unique tax treatment. Withdrawals are treated as a "return of contribution" first and as earnings second. This means that a person who has been contributing $5,000 per year for the past five years can withdraw $25,000 tax-free, provided the proceeds are used for qualified educational expenses. (Any withdrawals that exceed the total of one's contributions and are attributable to earnings will be taxable for those under age 59½.)
What I really enjoy about the Roth IRA is the flexibility it offers over the 529 plan. I have two teenagers of my own, and I've been contributing to their 529 plans since they were in diapers. I've always told them to shoot for the best schools, but as my children are now in high school, I've come to realize that my expectations for them may not precisely mirror their own hopes and dreams. One of my kids is working hard to get into a top-notch university, but my other child may not attend college at all.
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Unfortunately, any money I've saved in the 529 plan that is not used for educational expenses will not only become fully taxable as ordinary income but will also be subjected to a 10 percent penalty.
Many states offer a tax deduction for funds contributed to a 529 plan. If you reside in such a state, the 529 can be an attractive solution. But for the millions who live in the eight states that don't offer this tax break—including California, Massachusetts and New Jersey—the Roth IRA is both a terrific and flexible alternative.
Unlike a 529 plan, a Roth IRA allows people who have funds left over after withdrawing for college expenses to convert those dollars to retirement income—with no tax consequences or penalties whatsoever. Simply, this means that if Johnny or Jane doesn't use up all of the funds to pay for college, the remaining bucks can be used to supplement your own retirement income.
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Roth IRAs do have some drawbacks. First, there are contribution limits. For 2014 the maximum you can contribute is $5,500, or $6,500 for people age 50 and older. Second, you need to have earnings in order to contribute, making it virtually impossible for retirees to participate. Third, people with high incomes are prohibited from using this great tax tool. For a single taxpayer whose income exceeds $114,000, the Roth is phased out. For married folks the phase-out begins at $181,000.
The most widely touted college savings tool is the 529 plan, which clearly has merits and should be considered. But for many Americans, ignoring the Roth IRA as a college savings technique is an unfortunate mistake.
Below I have included a breakdown of the advantages and disadvantages of using a Roth IRA to fund higher education.
—Flexibility: Unlike 529s, Roth IRAs permit funds not spent on education to be used for personal retirement.
—Interest accumulates tax-deferred.
—Penalties are exempt when withdrawals are used for qualified educational expenses.
—There are strict contribution limits.
—You need to have "earned" income to contribute.
—People with high incomes are prohibited from participating.
—By Scott Hanson, Special to CNBC.com. Scott Hanson, a certified financial planner, is a senior partner at Hanson McClain Advisors in Sacramento, Calif.