Tips for using a Roth IRA to save for college

Experts answer questions about Roth IRAs, grandparents, scholarships and more.

  • By Chana R. Schoenberger,
  • The Wall Street Journal
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We again asked experts to help answer reader questions on the best way to save for college, including how to use tax-advantaged “529” accounts.

Q: I have decided to use a Roth IRA to save for my grandchildren’s college education. It is my understanding that you need as much in earned income as the amount contributed to the Roth for that year. My grandchildren are ages 1 and 7, so they don’t have jobs! How do I get around this problem? If I open a Roth IRA in my grandchild’s name, how much can I contribute yearly and how do they access funds without penalty in their 20s?

A: “While its primary purpose is saving for retirement, you can also use [Roth IRA] funds toward your grandchildren’s college education,” says Ksenia Yudina, the founder and chief executive of 529 app U-Nest Holdings.

Under Internal Revenue Service rules, you need to earn income before you can contribute to a Roth IRA, so your little grandchildren wouldn’t be able to have their own accounts, says Zaneilia Harris, president of Harris and Harris Wealth Management in Upper Marlboro, Md. But you yourself can fund a Roth IRA if you have income below $122,000 and are single or below $193,000 if you’re married, and you can name anyone as the beneficiary, Ms. Harris says.

“You can withdraw your original principal contributions tax-free at any time, as well as avoid the 10% early-withdrawal penalty [for investment gains] by taking an early distribution to pay for qualified higher-education expenses,” including tuition, fees, books, supplies and equipment, Ms. Yudina says. The details: You have to incur these expenses for an eligible member of your family, including your grandchildren, and pay the money directly to an eligible educational institution.

Once you are older than 59½, and have held your Roth IRA for at least five years, you can take money out for any reason tax-free. If you die after this point, your grandchildren, as the beneficiaries, can receive distributions over the course of their lives tax-free, Ms. Harris says.

This strategy doesn’t work as well as a 529 account for college savings, though.

“You are at a disadvantage if you use a Roth IRA for education expenses because you can only withdraw your principal contributions tax-free and penalty-free, while your investment gains are subject to income taxes, even if they’re withdrawn to pay for qualified higher-education expenses,” Ms. Yudina says. By contrast, money in a 529—both the funds you’ve contributed and any gains—can be withdrawn without taxes or penalties if you use it for qualified higher-education expenses. That’s why experts recommend using retirement accounts for educational savings only if the family doesn’t have a 529 account for their student.

Q: How does a grandparent who wants to fund an account for a grandchild put the account in the name of his or her child (the grandchild’s parent)? Isn’t that an effective gift to the parent from the grandparent?

A: If a grandparent sets up a 529 account with the parent as the account owner and the grandchild as the beneficiary, and writes a check to the grandchild to fund the account, that’s considered a gift to the grandchild; write the check to the parent, and it’s a gift to the parent, Ms. Harris says.

Q: What should you do when the grandparents of the beneficiary wish to bypass the parents of the beneficiary as owners of the 529 plan for fear the parents will dip into the fund for their own expenses rather than the educational expenses of their child (the intended beneficiary)? Would a reasonable workaround be to have the grandparents as owners until the beneficiary reaches age 18 and then transfer ownership to her or him?

A: If you don’t trust the child’s parents, you can set up a trust that will own the account once both grandparents have died, and designate this trust as the successor owner after the second grandparent is gone, says Ms. Harris.

“The trust will outline how you designate the distributions of the funds,” she says.

If the parents are untrustworthy, it’s a better idea to keep the money in the grandparents’ hands than to name the student as the owner, Ms. Yudina says. Keeping the grandparents as owners of the account during their lifetime not only prevents problems with the parents’ misuse of the money but also means the student will not be able to take out the money for anything but school.

“Grandparents can provide better oversight on the use of funds to make sure proceeds are only used for qualified expenses,” she says.

And for financial-aid purposes, while the best tack is to make the parents the account’s owner, if that’s not possible for these reasons, it’s better to keep the account grandparent-owned. If the student is the account owner, it will be considered a student asset on the Fafsa financial-aid forms, which will reduce the amount of aid the student can potentially get, Ms. Yudina says.

Q: My daughter receives a generous scholarship from her university. She received a Form 1098-T and, after preparing her taxes, was shocked to discover that she owes substantial taxes on a portion of this scholarship. If we withdraw money from her 529 funds to pay these taxes, would that be a qualified withdrawal?

A: No. Although you can take out of a 529 account the amount of money your student receives as a scholarship, and that’s considered a qualified withdrawal, you can’t take out money to pay taxes on the scholarship, Ms. Harris says. If you do, you’ll be liable for both income taxes on the gains portion of your withdrawal and a 10% penalty.

Q: Do you also avoid penalties if your child receives a fellowship or scholarship to graduate school? Can you withdraw the amount of the award penalty-free?

A: Yes. It’s the same as if your student had received a scholarship for undergraduate studies, Ms. Yudina says.

Q: Can I withdraw money from a 529 plan to reimburse myself for my student’s out-of-pocket expenses, for instance for a field trip run by her professor?

A: No. You’re only permitted, under IRS rules, to use 529 money for expenses required for graduation.

“What doesn’t fall under this definition, although you might think it does, are club memberships, transportation and travel, cellphone plan, out-of-pocket expenses, and student-loan repayment,” Ms. Yudina says.

Q: What happens when both parents are named as joint owners on a 529 account and there’s a divorce?

A: It’s up to the court, Ms. Yudina says. Once the court decides how to split the 529 assets, the parents should send this documentation to the 529 plan administrator. They will likely need to create a new account for the child and change the ownership on the original account so that each parent has a separate account for the child, she says.

Q: Our son works at a private middle school in a state that does not allow 529 moneys to be tax-deductible before college. His son, my grandson, attends that private school on a partial scholarship, which was reduced because I have set up a 529 for him, and it now has over $50,000 in it. Can I make my adult son the nominal beneficiary to lessen the impact of the 529 on future scholarship decisions? When the student finishes his sophomore year of college, we can make him the beneficiary.

A: Yes. “A great thing about 529 plans is that the beneficiary of the plan can be changed at any time to another qualified member of the family, and it’s not an overly complicated process,” Ms. Yudina says.

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