A few weeks ago a friend approached me very frustrated. His son just told him that he’s not going to college, which was a huge disappointment for my friend. But what further added to the pain was he had put away thousands of dollars every year into a 529 plan for his son, and now he couldn’t touch that money without picking up the gains on the growth and with a whopping additional 10% tax penalty. Ouch!
“Isn’t there a better way to save for college?” he asked me. “What do you recommend your clients do to save for college?”
“That’s easy,” I said. “Hire your kids - with the condition that they put everything in their Roth IRA.”
Roth IRA Funds Can Be Used for College1
Most people are unfamiliar with the rule that Roth IRA contributions can be used for qualified tuition expenses without incurring the additional 10% tax penalty. Furthermore, Roth IRA distributions have favorable ordering rules on distributions that allow contributions to come out before the growth comes out. That means if you contributed $5,000 per year for five years, that’s $25,000 you can pull out completely tax-free for college.
The IRS has a very wide definition on what qualified educational expenses are. Examples include:
- Books, supplies, and equipment required for enrollment or attendance
- Expenses for special needs services
- Room and board
The best part is any leftover funds can be used for other important life events. The obvious one is retirement which starts at 59 ½ for Roth IRA owners, and the principal and growth come out tax-free with no strict rules like the 401k’s notorious required minimum distributions. You can also take out up to $10,000 for a down-payment on your first home without incurring the additional 10% penalty. Furthermore, you can make distributions without the 10% penalty for financial hardships if you end up in dire straits. Money for nothing, checks for free! (Tax free, that is.)
Limitations on Moving Roth Money
Roth IRAs have strict limitations about who can contribute. If you don’t have earned income, you can’t make a contribution. There goes most of your children. If you make too much income (in 2015 over $116,000 if you’re single or over $183,000 if you’re married) then the amount you can contribute quickly phases out to zero. There goes most of our clients who are doctors, dentists, and small business owners. So the way around it is you put your child on the company payroll, have them open a Roth IRA, and contribute that earned income to the Roth. The maximum contribution for 2015 is $5,500.
Tax Arbitrage of Children on Payroll
An additional benefit of putting your child on the payroll is that you get a deduction in your business at the company’s tax rate (or your own if it’s a pass-through entity), and your child picks up the income at their bottom-of-the-brackets tax rate. Since their payroll is considered earned income, it’s not subject to the “kiddie tax” which usually would put your child’s tax rate at your highest marginal tax rate. So you can have a tax arbitrage of potentially 29.6% by putting your child on payroll. Not to mention your dependent still gets a standard deduction which could essentially mean the child pays zero tax if you paid them $5,500.
If you don’t have the ability to put your child on payroll, but they do have earned income from a part-time or summer job, you could simply give them the money up to the lesser of $5,500 and their earned income and have them contribute it directly to their Roth IRA. There would be no tax arbitrage, but you could at least get the account started and growing.
Beware the Five-Year Rule
Roth IRAs have one quirk that can catch you off guard: you cannot make any distributions from a Roth until you have owned the account for five taxable years2. This applies to all distributions – even retirement distributions for someone who is over 59 ½, and of course applies to the education exception and all other exceptions mentioned above.
You can shave off a year from the five year rule if you make a retroactive contribution in April 15th of the current year, and elect to have the contribution be for the previous year. For example, if it’s April 15th 2015, and you run down to your brokerage, open an account, and contribute even just one dollar, you start the clock ticking on the five-year rule as of January 1, 2014. That means on January 1, 2019 you are free to make qualified distributions like the educational distribution mentioned above.
The Bottom Line
To take advantage of using the Roth IRA to save for college, you should open an account today for your child. This will get the clock ticking on the five-year rule, and is a great opportunity to teach your children about financial planning and saving money for a rainy day. And who knows? Maybe getting your child interested in finances at an early age just might make them want to get that college degree after all.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
1 – See IRS Publication 970 Chapter 9
2 – See http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts#22