Using a Roth IRA for College Savings

A Roth IRA is a type of retirement plan where contributions are made from after-tax income and qualified distributions are tax-free. Since a return of contributions is tax-free even before the account’s owner reaches retirement age, a Roth IRA might also be suitable for college savings. It offers the flexibility of saving for retirement and for college in a single account. However, all distributions from a Roth IRA have a harsh impact on eligibility for need-based aid, regardless of whether they are included in adjusted gross income (AGI) or excluded from income.

Roth IRA

The Roth IRA is a qualified retirement plan. Unlike a traditional IRA, contributions to a Roth IRA are not tax deductible and may continue past age 70 1/2. But qualified distributions of earnings are excluded from income. In addition, the return of contributions is both tax-free and penalty-free even if the taxpayer has not yet reached age 59 1/2.

A qualified distribution of earnings occurs when at least five years have passed since the first day of the tax year in which the taxpayer first made a contribution or conversion to a Roth IRA and either the taxpayer reaches age 59 1/2, becomes disabled, dies or uses the distribution to purchase a first home (subject to a lifetime limit of $10,000).

Nonqualified distributions are subject to ordinary income taxes. Nonqualified distributions may also be subject to a 10 percent tax penalty. The 10 percent tax penalty is waived if the distributions do not exceed qualified higher education expenses, similar to the waiver for early distributions from a traditional IRA.

The 2013 annual contribution limits for a Roth IRA are $5,500 for taxpayers under age 50 and $6,500 for taxpayers who are age 50 or older. Contributions are also capped at the taxpayer’s taxable compensation. (This establishes practical limits on the amount of money that can be saved for college in a Roth IRA.) A 6 percent excise tax applies to excess contributions.

Financial Aid Impact

Although a return of contributions from a Roth IRA is excluded from income and, so, avoids income tax, it may have a harsh impact on eligibility for need-based financial aid. A tax-free return of contributions is reported as untaxed income on the Free Application for Federal Student Aid (FAFSA) and other financial aid application forms (such as the CSS/Financial Aid PROFILE form). Untaxed income is added to AGI to yield total income. As much as half of total income will increase the expected family contribution (EFC).

There are, however, a few potential work-arounds. One could wait until after the FAFSA is filed for the student’s senior year in college to take a tax-free return of contributions, when there is no subsequent year’s FAFSA to be affected. (It is unclear whether the distribution must be reported as untaxed income if the student subsequently files a FAFSA for graduate or professional school.) Another approach is to wait until after the student graduates and to use the tax-free return of contributions then to pay down student loan debt.

Coordination Restrictions

A tax-free return of contributions from a Roth IRA is not subject to any coordination restrictions, as the contributions were made from after-tax income.

Eligibility

There is no age limit on contributions to a Roth IRA.

Income Phaseouts

There are income phaseouts on contributions to a Roth IRA. These income phaseouts are adjusted annually for inflation and rounded to the nearest $1,000. The income phaseout for taxpayers who file federal income tax returns as married filing separately requires the spouses to have lived together at some point during the tax year.

Tax Year Single Filers Married Filing Jointly Married Filing Separately
2015 $116,000 to $131,000 $183,000 to $193,000 $0 to $10,000
2014 $114,000 to $129,000 $181,000 to $191,000 $0 to $10,000
2013 $112,000 to $127,000 $178,000 to $188,000 $0 to $10,000
2012 $110,000 to $125,000 $173,000 to $183,000 $0 to $10,000
2011 $107,000 to $122,000 $169,000 to $179,000 $0 to $10,000
2010 $105,000 to $120,000 $167,000 to $177,000 $0 to $10,000
2009 $105,000 to $120,000 $166,000 to $176,000 $0 to $10,000
2008 $101,000 to $116,000 $159,000 to $169,000 $0 to $10,000
2007 $99,000 to $114,000 $156,000 to $166,000 $0 to $10,000
2006 $95,000 to $110,000 $150,000 to $160,000 $0 to $10,000
2005 $95,000 to $110,000 $150,000 to $160,000 $0 to $10,000
2004 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000
2003 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000
2002 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000
2001 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000
2000 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000
1999 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000
1998 $95,000 to $110,000
$150,000 to $160,000
$0 to $10,000

One can bypass the income phaseouts by making contributions to a traditional IRA and then converting it into a Roth IRA.

There are no income phaseouts on distributions from a Roth IRA.

Expiration

The legislation authorizing the Roth IRA does not expire.

References

IRS Publications

Current Law

Legislative History

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