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Analysis | Millennials should use these Roth IRAs to invest in college

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If there’s one thing the impending start of the new school year makes clear, it’s that the cost of higher education in the United States is scary. Average tuition and fees for the 2021-22 school year are $10,338 at an in-state public college, $22,698 at an out-of-state school, and $38,185 at an out-of-state school. private, according to US News data.

However, based on rising costs each year, millennials can expect to see much larger bills by the time their children enter college. How can you prepare a child for college while securing your own financial future?

The most common answer is to use a 529 college savings plan. But for some families, I’d say the Roth IRA — yes, the retirement account — offers a more flexible way to build a college fund. your child.

In a 529 plan, contributions grow tax-deferred and withdrawals are tax-free as long as they are used for eligible educational expenses (including K-12). While there are no income restrictions and no annual contribution limits, there are lifetime contribution limits. Family members can also contribute to a 529 plan you have in place for your child.

The problem with 529s is that they can be restrictive. And it is ultimately difficult to predict the future of your child.

If they are not attending a college or other qualified institution – such as a trade or technical school – and you withdraw the 529 funds for a non-school expense, they will be subject to taxes and a potential 10% penalty. While there are options in case the original beneficiary is unrelated to college, you really need to be diligent about the eligibility rules when using the money. The plans may also come with higher fees and fewer investment choices compared to other investment strategies.

This is where the Roth IRA comes in. These are funded with after-tax dollars, so your future self, at age 59.5+, can withdraw both contributions and earnings tax-free. Depending on current and projected tax brackets, this can be a huge advantage, especially for young people investing for their retirement.

What many don’t consider is that these accounts can also be used to invest in non-retirement goals in a tax-efficient way.

If you’ve had your Roth IRA for at least five years, you can withdraw contributions at any time without paying a penalty — and you can use those funds however you want. (Note: This only applies to the after-tax contributions you made, not the earnings from those contributions. Withdrawing these early may result in a penalty tax.)

Millennials setting aside money for their children’s college fund should consider the Roth IRA as a way to do so — but if, and only if, it’s an additional retirement savings account. . This means you also have a 401(k) or other retirement fund to invest in for your own future. You don’t want to dip into your future nest egg to pay for your education (there are loans for that).

Roth IRAs are subject to phasing-outs in income, which may make them more accessible to younger Millennials and older Gen Zers who are not yet in their peak years. It also means paying income taxes while you’re in a lower tax bracket, which is likely lower than what you would pay in retirement.

Married parents with an adjusted gross income of $204,000 or less — and who file taxes jointly — can each contribute up to $6,000 a year to a Roth IRA. People 50 and over can contribute $7,000. Single parents with an AGI of $129,000 or less can contribute the same amounts. Those who earn more than these thresholds can contribute a reduced amount, unless you earn more than $214,000 as a married or joint filer or more than $144,000 as a single filer, in which case you are not eligible for a Roth IRA. (Many looking to circumvent these restrictions opt for a Roth IRA backdoor.)

Maximizing a single Roth IRA with $6,000 per year, starting in the year a child is born, would result in $108,000 in contributions by the time the child turns 18. Considering each parent can have an IRA, you could have double that. (And you can start contributing to the account even before a child is born.)

The Roth IRA loophole allows you to withdraw these contributions at any time, after five years, without tax penalty. The income from your contributions, meanwhile, can remain invested and grow for your use in retirement. If necessary, you may be able to withdraw income without penalty for education expenses, but you will still have to pay income tax if you are under 59 1/2. If you are over this age when your child enters university, you can withdraw both contributions and earnings without paying income tax or penalties.

Keep in mind that this does not also apply to a Roth 401(k). Despite similar tax treatment as a Roth IRA, you don’t have the same level of flexibility with contribution withdrawals.

There’s also a big catch: A Roth IRA withdrawal will impact your child’s financial aid options for school. The Free Federal Student Aid app will count withdrawals from a retirement account as income. Assets in retirement savings do not count against FAFSA, but withdrawals do. This means that your income for that year will appear higher on paper, even though all of those funds are paying for your child’s college education, and this could affect the amount of financial aid your child may receive.

If your child will rely heavily on federal student loans to pay the majority of tuition, then you should calculate the impact of a retirement withdrawal on their access to loans. Another option is to wait until their junior or senior years before taking withdrawals. FAFSA rulings are often made using tax income from the previous two years. Students applying for aid for the 2022-23 school year are encouraged to use their parent’s 2020 tax return.

Whether you choose a 529, a Roth IRA, or a blend to prepare for the cost of college, be sure not to deprioritize your future needs in the process. You don’t have to deprive yourself of a comfortable retirement in the name of sending your child to school.

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This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Erin Lowry is a Bloomberg Opinion columnist covering personal finance. She is the author of the three-part “Broke Millennial” series.

More stories like this are available at bloomberg.com/opinion

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