I believe being a Financial Planner is the greatest occupation in the world (at least for me), and there are numerous reasons why I think that. One of the reasons near the top of the list is the opportunity to develop creative solutions that truly improve our clients’ lives. One such opportunity recently presented itself to me when clients inquired about investing money for a new granddaughter’s college education.
As we do with all of our clients’ progress review meetings, we begin the meeting discussing the things that are new in their lives. This particular couple beamed with pride as they pulled out their cell phone to share pictures of their first granddaughter, born in the fall of 2014. They told me that they wanted to start a savings program for her education, and asked me which program I thought would be best for them in this situation. They specifically asked me to tell them more about the 529 savings program they had heard about.
As we moved through our meeting, I was able to dig deeper into the savings goal for their new granddaughter. To make a long story short, the creative solution we found was far different than what they expected: Instead of using a 529 plan; we decided to use a Roth IRA. In the end, three beneficial aspects of Roth IRAs stood out as reasons to utilize the Roth IRA for this goal.
- Flexibility and Ease of Access. While Roth IRAs are generally used for retirement savings, the planning flexibility they offer is often overlooked, even by many financial advisors. For the right situation, the benefits are incredible. Roth IRA contributions are allowed to be withdrawn tax and penalty-free at any age and at any time making Roth IRAs much less restrictive than traditional IRAs in terms of access. Roth IRA earnings are also withdrawn tax and penalty-free when certain conditions apply. In this particular case, these clients have owned their Roth IRAs for over 5 years and both spouses are over age 59 ½, so any earnings included in the distribution were going to be 100% tax and penalty-free.
- Broad Scope of Applicability. Another benefit you’ll find is that that Roth IRAs offer a wider range of uses than is available with two popular education savings vehicles: the Coverdell Education Savings Account and 529 plans. 529 plan distributions are intended solely for college tuition and associated expenses, and distributions for these purposes only are tax-free, not penalty free. Coverdell ESA distributions are tax-free for college, elementary and secondary educational expenses; however, if either of these types of accounts is used for purposes other than education, a portion of the distributions will likely be taxable. The Roth IRA permits withdrawals for any purpose, including education, and as long as certain conditions are met (as mentioned above) the distributions are tax-free.
- Investment Flexibility. The final benefit that really appealed to our client couple was the investment flexibility available with the Roth IRA. 529 plans offered by states generally limit the investment offerings in the plan to the funds of one mutual fund family. Roth IRAs have no such limitations, allowing mutual funds from any fund family, individual stocks, bonds, annuities, ETFs, closed end funds, and even CDs.
As is often the case in life, few solutions are perfect. There are two glaring flaws with using Roth IRAs for educational purposes.
- Contribution Limits. The first flaw is contribution limits. Both spouses can contribute $6,500 a year to their Roth IRA (including an extra $1,000 catch-up amount for being over age 50), making their maximum contribution for 2014 and 2015 $13,000 between the two spouses. 529 plan rules permit contributions of $14,000 per beneficiary per year without triggering gift tax considerations. In this case, the couple is currently planning for one granddaughter and not prepared to set aside more than a couple thousand dollars each year for her education, so the $1,000 difference in contribution limits between the Roth IRA and 529 plans is negligible. If the couple used Roth IRAs to save for multiple grandchildren’s educations, however, the contribution limits associated with Roth IRAs would restrict how much could be earmarked for each child’s education.
- Earned Income Limitations. The other flaw is that there must be earned income in order to contribute to a Roth IRA for any given year. Earned income includes compensation earned as salary, bonus, commission, etc., but does not include Social Security, pensions, dividends, or interest. That means retirees living on Social Security benefits, pensions and distributions from their investments and savings will be unable to contribute to a Roth. 529 plans have no such restrictions on contribution sources, so may become the preferred savings vehicle of retirees living on Social Security and pensions.
There are many other factors that must be considered when investigating the use of Roth IRAs for financial planning needs, including education planning. For the purposes of brevity, we have not discussed every single factor that must be considered when developing the appropriate planning solution. Roth IRAs are not a ‘one size fits all’ solution, and may not be the best strategy for every given situation. Roth IRAs are an effective planning tool, however, that too often get overlooked for planning purposes other than retirement. In this instance, Roth IRAs were the best solution to meet the clients’ desire for flexibility and control in planning for their granddaughter’s education.
Nothing in this article is to be construed as advice or a specific recommendation for the strategy described above. Consult a financial advisor to determine the appropriate solution for your situation.