Roth IRA Accounts: Intended for retirement, but accessible for education

Many people know about Roth IRAs as an effective retirement tool. But more than just as vehicles for retirement, Roth IRAs are also available for education planning.

They are an especially good option to consider when an individual is looking to contribute more than the Coverdell Education Savings Account (CESA) limit of $2,000, which we discussed in a previous blog.

First, a quick refresher on Roth IRAs. A Roth IRA is an individual retirement account (IRA) that allows qualified withdrawals on a tax-free basis provided certain conditions are satisfied. Roth IRAs are similar to traditional IRAs, with the biggest distinction being how they’re taxed. Roth IRAs are funded with after-tax dollars; the contributions are not tax-deductible. But once you start withdrawing funds after satisfying the requirements, the money is tax-free.

The annual contribution limit for Roth IRA is $6,000 for those under age 50. Those over 50 can contribute an additional $1,000 for both 2020 and 2021. Some requirements must be met for the distributions to be tax-free: 

a. The account must have been opened for five years

AND 

b. The account owner reaches the minimum retirement age of 59 ½, or in cases of death or disability.

In general, any distribution taken before age 59 ½ incurs tax on the earnings plus a 10% early withdrawal penalty.  The Roth IRA does allow first-time homebuyers to withdraw $10,000.

Once you reach 59½ and it's been at least five years since you first contributed to the Roth IRA, all of your withdrawals—earnings as well as contributions—are tax-free.  

If you’re not 59½ yet, withdrawals of earnings will be subject to income taxes, but not will not require you to pay the 10% penalty, as long as the cash is used for higher education expenses.

What qualifies for higher education expenses if the individual decides to pay for these expenses using a distribution from their IRA account? These expenses include the same ones as CESA: tuition, fees, books, supplies, and any equipment such as a computer. To qualify for room and board expenses, the student must be, at minimum, a “half-time” student. “Half-time” is defined as a student who is enrolled in half the course load of a full-time student, not that the student is attending only half of the academic year but with a full course load. There are additional requirements for room and board expenses. 

Roth IRAs are a great tax-free vehicle for college if an individual can satisfy the age and time requirements.

Once an individual Roth IRA account owner has reached the minimum retirement age of 59 ½, any distribution from the retirement account is tax-free and can be used to pay towards a college education. The account owner can be either a parent or grandparent who can contribute towards paying for a child or grandchild's higher education.

Additionally, with the Roth IRA, if the account owner makes a direct payment to the qualifying institution, the annual gift exclusion limit does not apply.  For example, if the parent deposits the funds directly in the child's account for the child to pay for education, then the annual gift exclusion of $15,000 ($30,000 for MFJ) applies. However, if the parent pays the qualified institution directly, then the annual gift exclusion does not apply. The same also applies to grandparents who use their tax-free Roth IRA distributions to pay for their grandchild's education. 

Roth IRAs are also attractive because money inside a Roth IRA isn't counted for financial aid purposes. However, withdrawals are counted, and that can affect your child’s financial aid package. This is because withdrawals are counted as income, even though the money isn’t taxed.

If you want to see if the Roth IRA is right for your family or want to ensure proper financial aid, gift, and estate planning, Luminous can help. We will run through the numbers together to help you avoid the 10% early distribution penalty and possibly minimize taxes owed from the distribution. 

Sources

1.  https://www.irs.gov/pub/irs-pdf/p970.pdf 

2.  https://www.irs.gov/taxtopics/tc310

3.  https://www.investopedia.com