How a Roth IRA For Kids & 529 Plan Impact FAFSA

When planning for your child’s future, every dollar saved counts-but how you save can have a significant impact on financial aid eligibility. With college costs rising, making informed decisions about savings tools is crucial.

Two of the most popular education savings accounts, Roth IRAs for Kids and 529 Plans, each offer unique advantages. But they differ in how they’re treated under FAFSA (Free Application for Federal Student Aid), which determines financial aid eligibility.

In this guide, we’ll explore:

• How FAFSA calculates financial aid
• How Roth IRAs for Kids and 529 Plans are treated under FAFSA
• A side-by-side comparison of these savings tools
• Strategies for minimizing FAFSA’s impact on financial aid

Why Choose a Roth IRA for Your Kids?

Choosing a Roth IRA for your kids is more than just saving for their future-it's giving them a powerful head start. A Roth IRA for Kids is hands down the best tool to build tax-free wealth, providing your child with the flexibility, financial security, and growth potential that other accounts just can’t match. 

Here’s why a Roth IRA for Kids is the ultimate choice for securing your child’s financial future:

• Tax-Free Growth: Gains in a Roth IRA for Kids grow entirely tax-free. In a standard brokerage account, up to 50% of your investment gains may go toward taxes over time, but with a Roth IRA for Kids, all growth remains yours to keep.
• Compound Interest: Your child has decades to benefit from compounding, which David Gardner described as “The magic of compounding returns is truly the most powerful force in investing.” Compounding allows small contributions to grow exponentially over time, creating substantial wealth by retirement.
• No Required Minimum Distributions (RMDs): Roth IRAs for Kids don’t require mandatory withdrawals, so your child’s savings can grow tax-free for as long as they stay invested.

Learn more about Roth IRA for Kids in our article ‘Why a Roth IRA for Kids Is the Best US Savings Account for Kids'

How Roth IRA For Kids and 529 Plans Differ in FAFSA Treatment

• Parent-Owned 529 Plans: Treated as parental assets, aid will be reduced by up to 5.64%.  Withdrawals for qualified education expenses don’t count as income.
• Student-Owned Accounts (e.g., UGMA/UTMA): Assessed at 20%, which can substantially reduce aid eligibility.
• Retirement Accounts (e.g., Roth IRAs for Kids): Balances are excluded from FAFSA, but withdrawals are treated as income and assessed at up to 47%.

Since FAFSA weighs income more heavily than assets, accounts that reduce taxable income (like Roth IRA for Kids) can offer strategic advantages.

Understanding FAFSA’s Financial Aid Formula

At the core of FAFSA is the Student Aid Index (SAI), previously known as the Expected Family Contribution (EFC). This number determines how much your family is expected to contribute toward your child’s education costs, based on both income and assets.

Why Income Has a Greater Impact Than Assets

FAFSA prioritizes income over assets because income is seen as a recurring resource for covering education costs, while assets are considered a safety net for long-term stability, like retirement or emergencies.

How FAFSA Calculates SAI

To avoid discouraging savings, FAFSA applies a higher assessment rate to income than to assets. Student resources, however, are weighed more heavily than parental resources, as students are expected to directly contribute to their education.

Income (highest impact on SAI):

• ‍Parental Income: Up to 47% of adjusted gross income (AGI) is factored into the SAI.

‍Example: If your AGI is $100,000, up to $47,000 may count toward financial aid calculations.

• Student Income: weighted more heavily - 50% of income above a certain allowance ($9,410 for 2024-2025) can impact aid eligibility.

Example: If your child earns $15,000, the first $9,410 may be protected, and 50% of the remaining $5,590 ($2,795) could reduce aid eligibility.

Assets (lower impact on SAI):

• Parent-Owned Assets: Assessed at a much lower rate than income, with a maximum of 5.64% being factored into the SAI. This percentage is part of FAFSA's federal methodology and helps ensure families can save without heavily impacting financial aid eligibility.

Example: A $10,000 529 Plan (a parent-owned asset) would reduce aid eligibility by just $564.

• Student-Owned Assets: Assessed at a much higher rate - 20% of their value is included in the SAI.

Example: A $10,000 student-owned account reduces aid by $2,000.

Roth IRA For Kids and FAFSA

A Roth IRA for Kids is a versatile tool, offering tax-free growth and dual-purpose savings for both retirement and education. But how does it interact with FAFSA?

Why Roth IRA For Kids Are FAFSA-Friendly

• Balance Exclusion: Roth IRA for Kids balances are not reported as assets on FAFSA, meaning they don’t reduce financial aid eligibility.
• Contribution Withdrawals: Contributions (the principal you’ve contributed) can be withdrawn at any time, tax- and penalty-free. These withdrawals are not counted as income on FAFSA, making Roth IRA for Kids an excellent way to save without impacting aid.

The Impact of Roth IRA For Kids Withdrawals on FAFSA

• Withdrawals of Contributions: Contributions can be withdrawn at any time, tax- and penalty-free, without being counted as income on FAFSA. This makes Roth IRA for Kids contributions a flexible funding source for education.

Example: If your Roth IRA for Kids holds $10,000 in contributions, you can withdraw that amount without affecting FAFSA.

• Withdrawals of Earnings: Earnings are subject to stricter rules:
  • For Qualified Education Expenses: Earnings can avoid the 10% penalty but will be counted as income on FAFSA, potentially reducing aid eligibility. ‍
  • For Non-Qualified Withdrawals: Earnings are subject to both income tax and a 10% penalty, limiting their effectiveness for education costs.

Strategic Use of Roth IRA For Kids for FAFSA

• Timing Withdrawals: FAFSA uses income from the "prior-prior year." Delaying withdrawals until the final two years of college can minimize FAFSA’s income impact.

Example: Income reported on the 2024 FAFSA is based on 2022 tax returns. If you wait until your child’s junior or senior year to withdraw, it won’t impact earlier FAFSA calculations.‍

• ‍Dual-Purpose Savings: Roth IRA for Kids can support both education and retirement. If funds aren’t needed for education, they continue growing tax-free for retirement.

529 Plans and FAFSA

529 Plans are tax-advantaged accounts specifically designed for education savings. Their treatment under FAFSA makes them a popular choice for families focused on funding college costs.

FAFSA Treatment of 529 Plans

• Parent-Owned Accounts: Assessed at 5.64% of their value, minimizing their impact on financial aid eligibility. Withdrawals for qualified expenses are excluded from income calculations.

Example: A $20,000 529 Plan reduces aid eligibility by just $1,128 (5.64% of $20,000).

• Grandparent-Owned Accounts: Starting with the 2024–2025 academic year, distributions from grandparent-owned 529 plans are no longer required to be reported as untaxed student income on the FAFSA. This change means that such withdrawals do not impact the student's financial aid eligibility, making grandparent-owned 529 plans a more attractive option for education funding.

Qualified vs. Non-Qualified Withdrawals

• Qualified Withdrawals: Tax-free and excluded from FAFSA income calculations, ensuring no reduction in aid eligibility.
• Non-Qualified Withdrawals: The earnings portion of the withdrawal is subject to income tax and a 10% federal penalty. Additionally the earnings is also counted as income on FAFSA, reducing aid eligibility.

Key Benefits of 529 Plans

• Tax-Free Growth and Withdrawals: Contributions grow tax-free and can be withdrawn tax-free, and withdrawals for qualified education expenses are also tax-free, providing a tax-efficient way to save for education costs.
• Minimal FAFSA Impact: Parent-owned accounts are assessed at a low 5.64% rate, preserving financial aid eligibility.
• Flexible Ownership Options: With the recent FAFSA changes effective in the 2024–2025 academic year, distributions from grandparent-owned 529 plans no longer affect the student's aid eligibility, offering families more flexibility in funding education.

Comparing Roth IRA For Kids and 529 Plans on FAFSA Impact

1. Financial Aid Impact

• Roth IRA For Kids: Balances are excluded from FAFSA assets, and contributions can be withdrawn tax- and penalty-free. However, earnings withdrawals are treated as income on FAFSA and could significantly reduce aid eligibility due to FAFSA’s weighting of income (up to 47%).
• 529 Plan: Parent-owned 529 accounts have a predictable and minimal impact at 5.64% on FAFSA, with withdrawals for qualified expenses excluded from income.

2. Flexibility

• Roth IRA For Kids: Contributions are accessible at any time for any purpose, providing unmatched flexibility.
• 529 Plan: Withdrawals must be used for education expenses to avoid penalties but can be transferred to another family member or rolled into a Roth IRA for Kids starting in 2024 (up to $35,000).

3. Tax Benefits

• Roth IRA For Kids: Contributions grow tax-free, and qualified withdrawals for retirement or specific exemptions are tax-free.
• 529 Plan: Contributions grow tax-free, and many states offer tax deductions or credits for contributions.

4. Long-Term Planning

• Roth IRA For Kids: Funds not used for education seamlessly continue growing for retirement, offering dual-purpose savings.
• 529 Plan: Tailored to education savings but now allows unused funds to roll over into a Roth IRA for Kids.

Learn more in our article ‘Roth IRA for Kids vs. 529 College Savings Plan vs. UGMA/UTMA Accounts’.

Strategies for Minimizing FAFSA Impact

• Time Withdrawals Carefully: FAFSA uses income from the prior-prior year. To reduce FAFSA impact, delay Roth IRA for Kids withdrawals until the final two years of college.
• Leverage Both Accounts: Use 529 Plans for predictable education expenses like tuition and room and board. Reserve Roth IRA for Kids contributions for emergencies or non-education needs.
• Optimize Account Ownership: Consider grandparent-owned 529 Plans, which no longer impact FAFSA income starting in the 2024-2025 school year. Use parent-owned accounts to minimize FAFSA’s asset assessment.

Explore State Tax Benefits: If available, take advantage of state tax deductions or credits for 529 Plan contributions to maximize savings.

How Mora Simplifies Roth IRA For Kids Planning

At Mora, we simplify the complexities of saving for college while preserving financial aid. Our services include:

• Expert Guidance: Tailored strategies for minimizing FAFSA impact and maximizing savings.
• Compliance Assurance: Ensuring withdrawals meet IRS requirements.
• Maximized Growth: Advice on balancing immediate education needs with long-term goals.

Get in contact with Mora today and take the first step toward smarter college savings!

FAQs About Roth IRA For Kids & 529 Impact FAFSA

Q: Are Roth IRA for Kids balances reported on FAFSA?
No. Roth IRA for Kids balances are excluded from FAFSA calculations.

Q: Do Roth IRA for Kids withdrawals affect FAFSA?
Yes. While contributions don’t count as income, earnings withdrawals are treated as income.

Q: Are 529 Plan withdrawals reported on FAFSA?
Qualified withdrawals are not counted as income, but non-qualified withdrawals are.

Q: Can unused 529 Plan funds be rolled into a Roth IRA for Kids?
Yes. Starting in 2024, up to $35,000 in unused 529 Plan funds can be rolled into a Roth IRA for kids the beneficiary.

Ready to get started? Let Mora’s experts simplify the process. Get in touch with the Mora team today!