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Is a Roth right for college?

| May 03, 2018

A Roth IRA is a great investment tool for many people, and one reason is its flexibility. Whatever money you put into a Roth, you can take out at any time without owing tax or paying a penalty to the IRS. So your Roth can double as an emergency fund.

It also can work as a college fund, and a Roth has its advantages when used for that purpose. Let’s say your student decides not to go to college. If you’ve sunk money into a 529 college-savings plan, you’ll take a hit if you withdraw it for non-educational purposes – a tax on any growth in the account plus a 10% IRS penalty. If you invest for college in a Roth IRA but don’t end up facing college bills, you can just leave the money in your account and have more for retirement.

There’s another advantage to using a Roth for college: You don’t have to report your Roth assets when applying for financial aid through FAFSA, the Free Application for Federal Student Aid. Parents do have to report 529 account assets held in their name. But the effect is usually modest: Only 5.64% of the money in their 529 account will be added to their expected family contribution the next school year. Seems reasonable to me for a fund earmarked specifically for education.

The tables turn if you withdraw money. Withdrawals from a 529 account are tax-free if used for qualified educational expenses – tuition, books or room and board, for instance.

As I mentioned, any money you put into a Roth IRA can be withdrawn without being taxed. But it’s a different story once you start to withdraw earnings – in other words, the growth upon your original investment. You’ll owe tax on the withdrawal of Roth earnings unless you’re at least 59½ and have held the Roth for five years.

Roth withdrawals can also bite when you apply for financial aid. Unlike withdrawals from a 529 account, Roth withdrawals count as income on FAFSA. And that’s true whether you withdrew your contributions or your earnings. You read that right: You won’t owe tax if you withdraw contributions, but they still count as income on FAFSA. And that can hurt your chances of securing financial aid.

So if you can swing it, build at least a modest 529 account to pay early college expenses. In many states, including Nebraska, you’ll get the bonus of a state tax deduction if you contribute to your own state’s 529 plan.

If necessary, tap your Roth money to pay for your student’s final two years of college. Why two years? Because when you fill out a FAFSA, you’re asked to report your income from two years earlier. For example, if you apply for the 2018-19 school year, you’ll have to report income from your 2016 return. So if you wait until your student’s final two years of college to touch your Roth money, you won’t have to report it as income.

It’s all the better if you can get through the college years without touching your Roth. That’s because it’s a wonderful retirement asset. Retirees I know love the fact that they can withdraw every dollar tax-free provided they’ve reached 59½ and had a Roth at least five years. And if they’re fortunate enough to end up with more money than they need, any unused Roth assets pass tax-free to their heirs.

The information presented is not intended as financial advice, and you are encouraged to seek such advice from your financial advisor. Signator Investors, Inc. and its representatives do not provide tax and legal advice. Please consult your tax advisor or attorney for such guidance.

A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

Investors should consider the investment objectives, risks, charges and expenses associated with municipal fund securities before investing. This information is found in the issuer's official statement and should be read carefully before investing. Investors should also consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available only from that state’s 529 Plan. Any state-based benefit should be one of many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investment in any state's 529 Plan.