28 Nov A Roth or home equity for college?

Q. I’m thinking of taking money from my Roth to pay tuition bills. It’s either that or a home equity loan. What are the advantages/disadvantages of both?
— Parent

A. We’re glad to see you’re closely considering your options before making a move.

Using a Roth IRA to fund college can be a tax-efficient strategy, but it’s one not many people think about, said Gerard Papetti, a certified financial planner and certified public accountant with U.S. Financial Services in Fairfield.

First, let’s cover some of the basic rules for a Roth.

Your contributions to a Roth IRA are not tax-deductible. Earnings grow tax-deferred and can be withdrawn income tax-free for any reason as long as you’re 59 1/2 and have had any Roth IRA established for five years or longer, Papetti said.

If you’re not yet 59 1/2 or if you haven’t yet had the account for five years by the time you need to take out the money for education expenses, you can still take distributions income tax-free and penalty-free because Roth IRA contributions can be distributed at any age, he said.

“Roth IRAs use the `FIFO’ method of taxation, meaning contributions are deemed to be withdrawn first and earnings second,” Papetti said. “For example, if you contributed $5,000 per year into your Roth IRA for five years, you will be able to take $25,000 out without any tax or penalty.”

The rules allow you to take a distribution from your Roth IRA for “qualified higher education expenses” and avoid the 10 percent pre-59 1/2 early distribution penalty if the taxable part of the distribution is less than the Adjusted Qualified Education Expenses, or AQEE, he said.

See IRS Publication 970, Section 9 for details on how to compute AQEE and the taxable amount of the distribution, if any.

Now that you’ve got that down, let’s look at the advantages of using a Roth for college bills.

Papetti said they offer flexibility.

“Roth IRAs permit funds not spent on education to be used for personal retirement, unlike 529 Plans,” he said. “Earnings accumulate tax-deferred, withdrawals are exempt from pre-59 1/2 penalties when used for qualified educational expenses, and Roth IRAs are not included as an asset for FAFSA purposes, unlike 529 plans.”

Now to the home equity option.

Both home equity loans (HEL) and home equity lines of credit (HELOC) are popular alternatives for funding education.

“The interest on up to $100,000 of Qualified Home Equity Debt — the loan must be secured by your primary or second personal residence — is deductible as an itemized deduction and can potentially reduce current income taxes,” Papetti said “Any interest expense on HEL/HELOC borrowing in excess of $100,000 will not provide a tax benefit.”

Papetti said the advantages of using home equity include the deductible interest, interest rates that are low and can be locked in if a fixed rate is available, payments can be flexible depending on your cash flow but must fund the minimum, which is typically the interest expense. A HELOC will provide flexibility to only borrow amounts that are needed as education expenses are incurred.

To take advantage of the interest deduction, you will need to itemize your taxes.

“The interest deduction may be limited or not beneficial depending on adjusted gross income as itemized deductions are phased out for upper income earners,” Papetti said.

Before you take from your home for education, know that it will reduce your ability to use it for other needs such as unexpected expenses, as an emergency fund or if you ever need a Reverse Mortgage to supplement your retirement income, he said.

Also keep in mind, he said, that if the interest rate is variable, the cost to borrow may increase if the variable rate increases.

“As you can see, there are more than a few reasons to consider using either your Roth IRA as a vehicle to fund a child’s education as well as using a home equity loan,” Papetti said.

That said, everybody’s situation is different and you should always evaluate all of your options to see what’s best for you and your family.

“I personally do not recommend that parents use any of their retirement resources or home equity to fund a child’s education unless they are confident they have more than enough capital/pension income to meet their retirement income needs,” Papetti said.

When he talks education funding with parents, he said he tells clients there are a multitude of options for a child to obtain student loans, which he said is not always bad idea, so the child has some commitment to fund their education.

“When all is considered I advise that before a parent uses their retirement accounts or home equity to fund their child’s education they consider have the student take out loans as it is much easier to obtain loans to fund a child’s education than it is to obtain a loan to fund the parents retirement,” Papetti said.

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This post was first published in November 2016.