Saving For College Using Your Retirement Plans:Tapping into Your Roth IRA

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Among the more recent entries into the retirement savings field, the Roth IRA has been a valuable addition, especially for many middle-income people who couldn't make tax-free contributions into a traditional IRA. If you meet the income limitations and are permitted to make contributions, Roth IRA's allow you to save money by making after-tax contributions into a retirement account. Over time, your money grows as it earns interest, dividends, and capital gains. When you finally begin to take distributions, your withdrawals come back to you completely tax-free. There is no tax-deferral element here, either at the front end, when you make your contributions, or at the back end, when you take withdrawals. Instead, you pay the income tax upfront and take withdrawals tax-free.

Making Distributions And Avoiding Penalties With A Roth IRA

Roth IRA's differ from traditional IRA's in many aspects, but especially regarding the distribution rules. There are certain requirements about who may take distributions and when they may take them. Failure to fulfill both of these requirements may result in a 10 percent penalty on the income portion of the distribution:

• Your Roth IRA account must be open for a period of five years before you may take any distributions tax-free. If you fail the five-year holding period test, the income portion will be taxed at your ordinary income tax rates, and you will, most likely, be charged a 10 percent penalty (although certain exceptions apply).
• Your distribution must satisfy one of the following conditions:
• It must be made on or after the date on which you attain the age of 59 and a half.
• It must be made to your estate or your named beneficiary on or after your death.
• It must be attributable to your being disabled.
• Up to $10,000 may be used to pay for qualified first-time homebuyer expenses.

Clearly, if you're an older parent or grandparent (over age 59 and a half) and you've had a Roth IRA sitting in the wings for at least five years, you're free to use it to pay whatever educational expenses you want. Because the distribution will be made to you and it's already designated as a tax-free distribution, you may choose to use that money for whatever purpose your heart desires.

If, on the other hand, you have a Roth IRA and you haven't yet reached that magic age, you're still allowed to take distributions from your Roth IRA to pay for qualified educational expenses. You should note, though, that the income portion of these distributions will be taxable to you, although no 10 percent penalty will be applied on money used to pay qualifying expenses. And here, the expenses that qualify are exactly the same as those for a traditional IRA. In essence, if you use your Roth IRA to pay for college and you're younger than 59 and a half, the net result to you is almost identical as it would be if you used your traditional IRA — you pay the income tax, but you avoid the penalty.

Playing With Roth IRA's Flexibility Without Getting Burned

If you're eligible to make contributions to a Roth IRA, it's a terrific way to save for the future. And, if you're an older parent, it gives you a great deal of flexibility when you're trying to determine how much to save for college and how much for retirement. With a Roth, you can gain many of the same tax benefits of a Section 529 plan or Coverdell Education Savings Account without limiting the use of your savings to only future educational expenses.

If you're okay with the idea of gifting money to your teenage children, you may want to think about opening a Roth IRA in their name. You need to know, though, that for this strategy to work, your children must be earning some money in each year that you make a gift into their Roth IRA, since only earned income is eligible to be contributed to a Roth account. Creating these accounts when your kids are barely earning allows contributions to be made while paying little or no tax on them, and then the money is free to grow for a longer period of time. Down the road, if your children need to apply for financial aid, this account (and any other retirement accounts, life insurance policies, or prepaid tuition plans that they may own) won't be included in the FAFSA calculation of the expected family contribution (EFC).