Saving for College with a Roth IRA: 8 Things You Need To Know

There’s been tons of media attention over the years on the best places to save for college.

The 529 savings plan has grabbed the most attention. I’ve used 529 plans for both of my kids through Vanguard, but today, I want to suggest another potential way to save for college:  a Roth IRA for your child. A Roth IRA won’t work for everyone, but it can be a fine option to stash some college cash. I also happen to have invested money in a Roth IRA for both of my children.

Here are eight things you need to know about saving for college with a Roth:

1. You can create a Roth if  your child has a job. A Roth is usually only going to work for a teenager, who is earning a salary. A friend of mine in Los Angeles got to start a Roth IRA much earlier for her son because he’s a child actor.

2. There are contribution limits. A teenager could theoretically contribute up to $5,000 into a Roth this year. But investors — regardless of their age —  can’t put in more than they made for the year. So if a teenage girl made $2,500 working at the local movie theater this year, that’s the maximum she could contribute to a Roth for 2010.

3. The teen doesn’t have to contribute to the Roth. Parents and grandparents are the ones more likely to tuck money into a Roth.

4. A Roth can cost less. One of the drawbacks of many 529 plans is that they are expensive. One reason is because each state acts as a middleman, which helps inflate the cost. Unfortunately, too many states have picked hideous 529 investment options.

With a Roth, you are free to invest in anything that the brokerage house or other financial institution offers. I’d suggest investing in index funds, which is where my children’s money is parked.

5. Money in a Roth IRA isn’t counted as an asset in financial aid formulas. The FAFSA doesn’t even ask about a teenager’s retirement accounts.

6. You can withdraw the Roth contributions tax free to pay for college. It’s best to leave the earnings (as opposed to the contributions) inside the account because they will be subject to taxes and a 10% early withdrawal penalty.

7. The Roth has one financial aid drawback. While aid formulas don’t penalize a teenager for having assets in a Roth, once that cash is withdrawn to pay for college, the formula does care. The withdrawn money is considered student income. This wouldn’t be an issue if the money is withdrawn after you complete your final financial aid application during the late winter or spring of your child’s junior year in college.

8. A Roth is a great starter retirement account. If any money is left in the Roth when a child leaves college, the new graduate can begin adding to the Roth, which is a fabulous way to save for retirement.

Lynn O’Shaughnessy is author of The College Solution and she also writes a college blog for CBSMoneyWatch.