For college-bound students, funding retirement has to be the farthest thing from their minds. Yet, with a little planning, parents may be able to kill two birds with one stone. Unfortunately, most parents of college-bound kids tend to overlook some obvious ways to lower the cost of college but wisely using the tax code and some retirement planning techniques can help.
It may be a low-priority item, but this strategy can help parents when it comes to planning how to pay for college. How? By lowering the Expected Family Contribution (or EFC) of the family and sheltering assets in a retirement account, there is the potential for qualifying for more needs-based financial aid.
Consider using a Roth IRA for any earnings that a student has from part-time work. For students over 16 they can put away up to $5,000 each year (or up to their total earnings, whichever is less) from all those part-time or summer jobs. Students already in college can also use this same strategy.
A Roth IRA allows any wage earner regardless of age to put money away now and then later withdraw money without paying taxes on the earnings. When you contribute to a Roth IRA, there is no tax deduction as there is with a traditional Individual Retirement Account (IRA) but there are other advantages.
If a student earns money and the parents leave it commingled in one of their accounts, the balance will potentially be assessed at the student’s higher rate as an asset available for paying for school. Parents may want to maintain control over funds and have the earnings put into an account in their name but this will show up as a parental asset subject to assessment by the financial aid formulas used by colleges.
On the other hand, funds in a Roth IRA are not counted and will not affect financial aid calculations.
Follow the Road Map
The key to this strategy is following the rules of the road. Any funds placed in the account as a contribution may be withdrawn at any time free of taxes or penalties.
For earnings that may accrue on the account balance, these may be subject to income taxes or penalties but there are exceptions.
For amounts that were converted from another IRA and recharacterized as a Roth, there are special rules. For amounts that meet the five-year holding test (from the date the account was first opened) then no income taxes or early withdrawal penalties apply. If a withdrawal is made within five years, then a 10% early withdrawal penalty applies unless it is for a special purpose. One of the eight special purposes is withdrawals used for higher education expenses.
Withdrawals of Earnings
While income taxes will apply, no 10% early withdrawal penalties apply when the proceeds are used for one of eight special purposes including higher education expenses.
For distributions from a Roth IRA you need to note that Roth contributions are always considered to be the first amounts withdrawn. These are not taxable. Then any amounts that were converted from other IRAs are considered to be withdrawn second and subject to the time line noted above. Finally, earnings on the account are considered to be withdrawn last.
Ideal for the Self-Employed Parent
Consider employing your kid in your business and paying them instead of just giving them an allowance. I write about this on a previous blog found here. This way you can lower the taxable profit from your business which may help you qualify for more financial aid. And by diverting the wages earned into a Roth IRA as a contribution, your child will not have this asset exposed for the financial aid calculations.
Use It Now or Later
This strategy can be used for late-starters, those who haven’t saved enough for upcoming college bills.
But it can also work very well if you start early. Since there is a five-year rule in place, open a Roth IRA account even while the child is in middle school and working part-time outside the home or in the family business. Then by the time the child is ready to enter his third or fourth year of college, he may be able to withdraw some of the earnings to pay for costs without paying any penalties.
By using this strategy, parents can help their students learn to save and the funds can be available in a tax-efficient way during college to pay qualified education expenses. Or they can skip the withdrawals while in college and use them later for graduate school or to help pay for their first home purchase.
Advantages of This Strategy:
- Shelters assets from financial aid calculations
- May help lower family Expected Family Contribution (EFC)
- Instills value of saving early for goals
- May help accumulate capital that can be used later for school with tax efficient withdrawals
- May help save for future home purchase or better yet … retirement