This blog contains some simple tips and advice from two regular guys. We're not accountants, financial advisors, or brokers, so follow, ignore, or discuss our ideas as you see fit.

Wednesday, September 12, 2007

The Roth as a College Savings Vehicle

Posted By Paul
There are many options out there when it comes to saving for college. I had heard that some people use a Roth IRA as a college savings vehicle and this idea intrigued me.

The article Matt wrote already outlines the basics of the Roth IRA. So I was interested in how this applies to college savings.

So with a Roth you put post-tax dollars into an account and earnings that you make are tax free. You can withdraw your contributions at any time for any reason without taxes or penalty, but if you withdraw earnings early (before age 59 1/2) then you pay a 10% penalty tax AND you have to pay taxes on the earnings.

So how does this become a college savings vehicle? Well the answer is that if you withdraw earnings early and use them for higher education expenses then you avoid the 10% penalty tax but you still have to pay taxes on the earnings.

One reason this appeals to people is because the Roth sort of provides a savings vehicle that can be used to save for a child's college, but also can serve as something else.

For example, if you save all of this money in a Roth, but then out of nowhere your grandparents offer to pay for your child's college education (this is a VERY hypothetical case for most people) your Roth can still serve as your retirement account.

Another cool trick is that you can use your Roth as a combined college savings and retirement account. Let's say for example that you reach a point where you decide you can save $500 per year for college and another $1500 for retirement. You can take the whole $2000 and put it into a Roth IRA.

So now fast forward to the future. Let's say that over the years your $2000 became $3000. That means that the $1500 for retirement has grown to $2250 and the $500 has grown to $750.

Now you decide that you want to take some money out for college expenses. If you can take out the $750, and as far as the IRS is concerned you're still taking out less than the total money you have contributed, so this money is yours, tax free and penalty free.

There is a great article on college savings through the Roth here. The idea of using a Roth for college savings is interesting, but I think I'm going to keep looking around. I plan on researching (and posting articles) about other options in the future.


Matt said...

Yes, this is yet another reason to take advantage of the Roth IRA. The government is giving us a great savings vehicle that not only rewards you for saving (with tax-free earnings), but also limits you (via disincentives) to spending the money in ways that most people would agree are worthwhile and smart (retirement, education, $10k towards a first home). If only the contribution limits were higher!

Matt said...

Here's another option to consider: If your child has earned income (child modeling, lawn mowing, babysitting), you can open a Roth IRA in their name. You can even contribute to it, as long as the total account contributions don't exceed the child's earnings for the year or the regular contribution caps.