Use Roth IRAs to Save for College

Roth IRAs are subject to income phaseouts, which can make it more accessible to younger millennials and older Gen Zers who are not in their peak earning years yet. It also means paying taxes on income while you’re in a lower tax bracket, which is probably less that what you’d pay in retirement.

Married parents with an adjusted gross income of $204,000 or less — and who file taxes jointly — can each contribute up to $6,000 a year to a Roth IRA. Those 50 and older can contribute $7,000. Single parents with an AGI of $129,000 or less can contribute the same amounts. Those earning more than these thresholds can contribute a reduced amount unless you earn more than $214,000 as married, joint filers or more than $144,000 as a single filer, in which case you are ineligible for a Roth IRA. (Many looking to get around these restrictions opt for a backdoor Roth IRA.)

Maxing out just one Roth IRA with $6,000 annually, starting the year a child is born, would result in $108,000 of contributions by the time a child is 18 years old. Considering that each parent can have an IRA, you could have double that. (And you can start contributing to the account even before a child is born.)

The Roth IRA loophole allows you to withdraw these contributions at any time, after five years, without a tax penalty. The earnings on your contributions, meanwhile, can stay invested and grow for your use in retirement. If necessary, you may be able to withdraw earnings penalty-free for education expenses, but you’d still need to pay income tax if you’re under 59 1/2. If you’re over this age when your child goes to college, then you can withdraw both contributions and earnings without paying income tax or penalties.

Keep in mind that this does not equally apply to a Roth 401(k). Despite having a similar tax treatment as a Roth IRA, you do not have the same level of flexibility with contribution withdrawals.

There is also one big catch: A Roth IRA withdrawal will impact your child’s financial-aid options for school. Free Application for Federal Student Aid will count withdrawals from a retirement account as income. Assets in retirement savings don’t count against FAFSA, but withdrawals do. That means your income for that year will look higher on paper, even if all those funds are paying for your child’s college education, and this could impact how much student aid your child can receive.

If your child will be heavily relying on federal student loans to pay for the majority of college tuition, then you should do the math on how much a retirement withdrawal will impact their access to loans. Another option is to wait until their junior or senior years before taking the withdrawals. FAFSA decisions are often made using the tax income from two years prior. Students applying for aid in the 2022-23 school year are asked to use their parents’ 2020 tax return.

Whether you pick a 529, a Roth IRA or a mix to prepare for the cost of college, make sure you do not deprioritize your future needs in the process. You don’t have to rob yourself of a comfortable retirement in the name of sending your child to school.

(Image: Adobe Stock)

For more Bloomberg Opinion columns, visit http://www.bloomberg.com/opinion.

Erin Lowry is a Bloomberg Opinion columnist covering personal finance. She is the author of the three-part “Broke Millennial” series.