A Clever Financial Aid Strategy: Use Roth IRA Distributions to Pay Off Loans

By Jeffrey Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott

On Monday, we posted an article to The Slott Report detailing 3 reasons why you may want to use a Roth IRA instead of a 529 plan to help save for a child’s college education. Since then, we’ve received a fair amount of feedback from readers and follow-up questions, many of which sound something like this …

“If I use my Roth IRA to pay for my child’s education expenses as they are incurred, won’t that impact their aid in future years?”

The answer to this question is generally yes. If you take a distribution from your Roth IRA to pay for your child’s college education this year, it could definitely impact the aid they are eligible to receive in future years. There is, however, a clever workaround for this problem. Simply take out loans – or have your child take out loans – to pay for educational expenses as needed, and then, later, use Roth IRA distributions to help pay off that debt.

There are several advantages to this approach, including:

#1 – Help Maintain Financial Aid Eligibility Throughout a Child’s Education

Although your Roth IRA isn’t counted as an asset for FAFSA purposes, if you take a distribution from your Roth IRA, it will be counted as income for FAFSA purposes – even if it’s a tax-free distribution. So, if you use a Roth IRA to save for a child’s college education, everything will probably be fine the first year you fill out your FAFSA form, because you will not yet have needed to take a distribution to pay for any college-related costs. However, if you take a distribution from your Roth IRA to help pay tuition or other expenses for your child’s first year of college, it might reduce or eliminate their eligibility for aid in future years.

If, on the other hand, you use student loans to pay for education expenses, you can wait until your child no longer needs to file a FAFSA form for aid and then use distributions from your Roth IRA to help repay those loans.

#2 – You may be Entitled to a Deduction

In many cases, the interest you pay on student loans is a deductible expense. If you take out a student loan for a dependent child, you can deduct the interest you pay on those loans as an above-the-line deduction on your federal tax return. As an above-the-line deduction, it is not impacted by the so-called “3% haircut.” The deduction can be reduced or eliminated, however, if your income exceeds certain thresholds. In 2015 the phase-out range for single filers is $65,000 – $80,000. The phase-out range for married couples filing joint returns is $130,000 – $180,000.

#3 – Help Your Child Build Credit

In today’s world, a person’s credit score is incredibly important. Establishing and maintaining good credit can help a person pay less when they buy a car and, more importantly for many, purchase a home. In fact, the difference between having good credit and bad credit – or even just average credit – can amount to many thousands, if not hundreds of thousands of dollars over the course of a lifetime.

If your child takes student loans and consistently makes timely payments, it can really help boost their credit score. And there’s nothing in the law that prevents you from taking distributions from your Roth IRA and gifting the proceeds to your child to help them repay their loans.