College is expensive, and it’s not just about the tuition and school fees. Textbooks are costly, even the digital versions. Unless the student lives at home, there are boarding, food and transportation expenses. The average cost of a public four-year school for the 2018-2019 school year was $21,370 (tuition, fees, room and board) and $48,510 for a private school.1 When you multiply that by four (or more) years, the total cost of higher education is sky high.
Paying for College
While most parents plan to save for college, other expenses often take priority in the years between kindergarten and high school graduation. Many families can’t afford to pay the “expected family contribution” the federal student aid application program FAFSA says they should. Student loans are a helpful option when financial aid and savings have run out, but racking up loads of debt is not ideal either. Right now, student loan debt is at an all-time high for Millennials, their parents, and even their grandparents. One study shows that 70% of 2017 college graduates who took out a student loan averaged $38,000 in student loan debt.2 And, the number of people over age 60 with student loan debt has quadrupled in the last decade from 700,000 to 2.8 million.2 Paying for higher education is a problem, and carrying this debt burden is keeping many workers from achieving other financial goals.
Of course, the best thing to do if you want to help your kids with college expenses is to start saving as soon as possible. Work with a financial advisor to determine the amount you need to save per year to reach your goals and where it might make the most sense for you to save and invest. Many advisors recommend a 529 college savings plan. But 529 plan assets must be used for education expenses or the investment earnings will be taxed and penalized. For this, and other reasons, some advisors recommend a Roth IRA as an alternative for college savings. In fact, a Roth IRA can be used to meet a variety of savings goals including short term goals (like college) and long-term goals (like retirement) – all in one account.
A Roth IRA Strategy
A Roth IRA can be a great way to help pay for college expenses because, unlike distributions from other retirement savings arrangements, Roth IRA distributions are rarely taxable. All Roth IRA contributions, including conversions, have already been taxed, so there is no additional taxation when they are removed – no matter your age or reason for taking a distribution. You can use some of your Roth IRA assets tax-free when you need them to help pay college expenses, while you continue contributing and investing into the same Roth IRA to build your retirement savings.
Tax-Free Qualified Distributions
When you meet the requirements for a “qualified” distribution, you can distribute your entire account balance, including investment earnings, tax-free. For a Roth IRA distribution to be a qualified, you must meet two requirements.
• Five calendar years have passed since you first made a Roth IRA contribution and
• You have reached age 59½, become disabled, died, or are making a first-time home purchase (for yourself, your spouse, a child or grandchild).
If your Roth IRA distribution is not qualified, any investment earnings included in a distribution will be taxable and subject to the 10% early distribution penalty.
Tax-Free Nonqualified Distributions Too
Many parents do not meet the qualified distribution requirements at the time their children enter college. Because of the Roth IRA distribution ordering rules, however, you can still take tax-free withdrawals to pay college expenses so long as you don’t withdraw your entire Roth IRA balance:
• The first assets distributed are considered to be drawn from the annual contributions you made to your Roth IRA. Because these contributions are made with after-tax dollars, any distributions of just these assets will always be tax-free.
• After you have distributed an amount equal to all the annual contributions you have made, distributions will come from amounts you have converted or rolled over from a pre-tax retirement account to your Roth IRA. A distribution from this pool of assets will also be tax-free. It is subject to the 10% early distribution tax if the conversion occurred within the past five years, but a distribution taken to pay higher education expenses is an exception to this additional tax.
• After you have removed all contribution and conversion dollars from your Roth IRA, the investment earnings will be the last to come out. These assets will be taxable to you (and subject to the 10% early distribution tax) if you take them out before you meet the requirements for a qualified distribution.
Ideally, you would not deplete your Roth IRA to assist with college expenses. Rather, by using just a portion of the amount you have contributed, you can access tax-free savings to help pay for college but not put your own retirement savings goals at risk.
Talk to your financial advisor about whether a Roth IRA fits into your college savings strategy and the types of investments that are appropriate now, while you’re growing assets, and later, when you might need access to your savings. You’ll also want to learn how to track your annual contributions accurately, so you know how much you can take out tax-free before you meet the requirements for a qualified distribution.
If you have questions about Roth IRAs or distribution options, please contact us at 866-928-9394 or Service@StrataTrust.com.
1 CollegeBoard, Trends in Higher Education, https://trends.collegeboard.org/college-pricing/figures-tables/average-published-undergraduate-charges-sector-2018-19
2 Debt.org, America’s Debt Help Organization, Students & Debt, https://www.debt.org/students/