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What is a Backdoor Roth IRA and How to Use a Roth IRA for College Savings

My previous post covered some of the fundamentals of a Roth IRA account.  This post will discuss the backdoor Roth and how Roth accounts can be used as a type of college savings tool.

Benefits of Backdoor Roth IRAs

Two of the greatest benefits of a backdoor Roth are they allow you to get around the contribution limit as well as the income limit.  There are no limits for either. 

A backdoor Roth may be a good option for you for a few reasons.:

Benefit #1:

One, is if you have a dip in income in a particular year that drops you into a lower bracket and you can convert funds in your current IRA at this lower rate.  This can be a particular good tool early in retirement if your earned income drops to lower rates.

Benefit #2: 

Two, if the income limits of a Roth keep you from contributing, you may want to consider contributing to a regular IRA and then converting it to a Roth.  There are no income limits to contribute to a traditional IRA, so you contribute and convert it to a Roth. (note, there are income limits on what can be deducted when contributing to a traditional IRA) Also, you can convert whatever amount you have in a traditional IRA into a Roth.  

It is also important to note that this isn’t a way around taxes.  Whatever amount of pre-tax money you convert from a traditional IRA to a Roth will be taxed.  Therefore, special attention must be paid to make sure you don’t convert too much and kick yourself up into the next tax bracket and end up paying more taxes than would be prudent.  

Roth IRAs for Legacy Planning

A Roth IRA account may be used as legacy planning tool as well.  Although no required minimum distributions (RMDs) are required from a Roth, they are required from a traditional IRA.  But even if you are over the age of 70 ½, and as long as you take your RMD first, you can convert a portion or all of your traditional IRA to a Roth.  And pay attention to timing, each conversion starts its own 5-year holding period. (5-year holding period discussed in previous post.)

Conversions should also be considered if you believe tax rates are relatively low now and unlikely to go much lower in the future.  I’d say this is a good bet at the moment.  Assuming values increase, the longer the time-frame your dollars are in a Roth, the higher the benefit will be. 

Roth IRAs for College Savings

When considering a Roth IRA account for college savings, the first thing to consider is how old you will be when your child is in college. If you will be 59 ½ or older, (and you’ve met the five-year holding requirement), you can use your Roth dollars to pay for anything, including college with no tax implications or penalties. 

Now, if you will be younger than 59½ when your child is in college you can still use Roth money for college expenses, but your distribution will not be qualified.  How can you do this and pay no taxes or penalties?  Well only the earnings portion of your distribution would be taxable, not the contribution portion.  

The idea is to withdrawal the contribution portion of your Roth dollars and leave the earnings portion, so you pay no income tax. Non-qualified distributions from a Roth IRA, withdrawal contributions first and then earnings, so you could theoretically withdraw up to the amount of your contributions and not owe income tax.

Key to this strategy is the 10% early withdrawal penalty that normally applies to distributions before age 59½ is waived if you use Roth dollars to pay for college.  So, if you use Roth dollars to pay college expenses and you’ll be younger than 59½ when your child is in college, you might owe income tax (only on the earnings portion of the distribution), but you won’t owe a penalty.

One last perk is that retirement assets aren’t counted by the federal or college financial aid formulas. Therefore, your Roth account balances won’t affect financial aid.

*As always, be sure to consult your tax consultant or financial planner before implementing any of the ideas above.  But the flexibility and benefits of a Roth IRA account should not be overlooked with almost any plan. 

Could a backdoor roth be right for you?