Avoid This Trap When Using a Roth IRA to Pay for College

05/15/2015 03:54 pm ET | Updated May 13, 2016

Paying for college is challenging enough. Paying for college while saving for retirement can be nearly impossible. There is only so much money to go around. Roth IRAs can be a great way to bridge the gap between paying for college and saving for your own retirement.

Roth IRAs are funded with after tax dollars but the earnings grow and are distributed tax-free, if you have had the Roth IRA for 5 years or more and are over age 59 ½. Even if you are younger than that when your student goes to college, the principal can be taken out tax-free and used for any purpose.

When my girls were younger, I used to think a Roth IRA would be a great way to save for college. In fact, I still do.

My wife and I could each contribute $5,000 or more to our Roth IRAs (the maximum contribution was lower back then) for the 12 years they were in school. Assuming our Roth IRAs didn't lose any money (a big assumption in those days) we should have up to $120,000 in Roth IRA principle we could draw from to help pay for college. Best of all, any earnings can stay in the account and continue to grow tax-free for our retirement.

For three reasons why a Roth IRA works so well for college savings, check out this post on The Slott Report.

This strategy works great unless your student is eligible for need-based financial aid. Then it blows up in your face. Here's why: Need-based financial aid is largely based on information regarding the student's family's income and assets. This information is typically provided on the Free Application for Federal Student Aid or FAFSA in the winter of a student's senior year of high school.

On the FAFSA form, distributions from a Roth IRA are considered "untaxed income" and are treated like income in the same way that income from your job is. What's worse, income is treated more harshly on the FAFSA form than are assets. Since parents' assets are assessed at a rate of 5.6%, some families may be better off in more traditional college savings accounts than by taking distributions from their Roth IRA. In some cases, distributions from a Roth IRA could cost you more in lost financial aid dollars than you gain in tax savings with other types of investments.

On the other hand

Roth IRAs, like all IRAs, are exempt assets and not included on the FAFSA form. How do you know which is the best strategy? Calculate an estimate of your Expected Family Contribution or EFC. That's the number that the FAFSA calculates to determine how much your family is expected to chip in for college. The idea is to keep that number as low as possible.

To calculate an estimate of your family's EFC check out the EFC calculator on the College Board website. Run the numbers both ways and see what works best for your family.

Do your homework

Every family's situation is different and the rules regarding financial aid change often. Do your homework and make yourself a smart consumer of a college education.

If you need help bridging the gap between paying for college and saving for retirement, just ASK MIKE.