Roths, Costs, and Fiscal Rock 'N Roll
Tired of wading through the college savings swamp yet? Do not worry, we are almost done. One of the few places where parents can shelter funds away from the watchful eye of the federal financial aid formula is by storing cash in a retirement account held in either the parent or student's name. Unlike 529 plans, retirement funds (along with funds stored in cash value life insurance policies and home equity) will not count at all on the federal financial aid formula and can, but don't have to, be used for educational purposes. That means more flexibility with your money AND a bigger government check.
For college savings purposes, the darling of the retirement account world is the Roth IRA. Armed with a loophole that allows account holders to withdraw funds for college without paying a penalty, Roths also provide income tax incentives by allowing your funds to grow tax free. More financial aid, more tax incentives, more fiscal flexibility, no penalties.
The downside is that the rules on Roths are strict. Families must own a Roth for a minimum of 5 years before dipping into it. There are yearly contribution limits—$5,000 for account holders under age 50, $6,000 for those over age 50—and families can only use contributions to pay for college without paying taxes. You will have to pay income tax on any earnings you use from the account.
While Roths can provide more financial aid, they frequently do not. In fact, families who invest in a Roth IRAs oftentimes wind up losing more in financial aid than they would have with a 529 plan or even a savings account. Here is why Roths can simultaneously be the best and worst college savings vehicle:
Funds stored in a Roth will not count from your federal financial aid package. That means that even if your family has $1 billion stored in a Roth, none of that money will factor into your government financial aid package. Once families start withdrawing from a Roth, that money counts as income and can subtract from your aid package by up to 47 cents for every dollar you have withdrawn. That is basically taking your government check and chopping it in half. Luckily, there is a work around: Spend your college savings backwards. Since students apply for federal aid using income and asset figures from the year before—meaning that if you are entering college in 2012, your financial aid package will be based on your family's financial situation from 2011—families can sidestep losing financial aid on a Roth IRA by only using Roth funds to pay for the student's senior year of college. By the time the federal government realizes you've taken a Roth distribution for school, you will (hopefully) have graduated and will not need any more sweet, sweet financial aid.
College Savings Cheat Sheet: Roth IRAs
Accessibility: Good. You can withdraw Roth funds tax-free before age 59 1/2 without penalty for any qualified educational expense or simply save it for retirement. :)
Risk Level: Subject to the market. :
Rate of Return: Depends on what's in your account and how the market performs :
Tax Benefits: Moderate. Federal income tax incentives available; no state tax benefits. :
Impact On Your Financial Aid: Nada, if saved to pay for the last year in college :)