When you ponder saving for college, you may think your options are limited to a 529 college savings account or a regular brokerage account. However, many parents are using individual retirement accounts (IRAs) or Roth IRAs to help pay for college expenses while enjoying tax savings. Here we discuss a few key things parents should know about using IRAs for college savings.
Using a Roth IRA to Pay for College
Roth IRAs are among the most versatile retirement accounts out there. Not only are Roth withdrawals, including gains, entirely tax-free, but Roth contributions can be withdrawn without penalty at any time as long as the account has been open for at least five years.1 In other words, if you've contributed $50,000 to your Roth over the last decade, you'll be able to withdraw the full $50,000 tax-free and use it to pay for your child's college expenses.
This plan isn't without some caveats, however.
Once you withdraw funds from your Roth IRA, those funds are gone—you can't replace your prior contributions. So it is important not to withdraw any more than you need, or these funds will no longer enjoy their tax-protected status. This is especially important if you're approaching the income limit for Roth contributions; you may withdraw Roth funds and then realize you're no longer financially eligible to contribute more in the future.
If you withdraw contributions and gains for qualified education expenses, you will avoid a 10 percent early withdrawal penalty on the withdrawn gains. However, you'll owe income taxes on the amount you withdraw. Only if you are age 59½ or older can you withdraw both your contributions and your earnings with no penalty or tax.
Finally, Roth IRA withdrawals are considered "untaxed income" that must be reported on the Free Application for Federal Student Aid (FAFSA). The higher your income, the less need-based aid your child will qualify for.
Using a Traditional IRA to Pay for College
A traditional IRA can also be used to pay for qualified education expenses. As with a Roth, withdrawing funds from an IRA for qualified education expenses will allow you to avoid the 10 percent early withdrawal penalty; however, you'll need to pay taxes on the amount withdrawn regardless of whether the funds were contributions, gains, or both.
And like Roth withdrawals, traditional IRA withdrawals are reported as income on the FAFSA and calculated as part of the "expected family contribution" to the student's expenses. The only exception is if your child is considered "independent" for FAFSA purposes—that is, if they are age 24 or older, married, enlisted in the armed forces, or if they have children.2
Before withdrawing funds from a Roth or traditional IRA, it is a good idea to talk to your financial professional. A suitable path for you and your student will depend on your income, your tax liability, the estimated cost of attendance at your child's school, any scholarships, loans, or grants that are available, and a variety of other individualized factors. While Roths and IRAs can be valuable tools in your child’s college funding process, there are benefits and drawbacks to each method you should consider before taking action.
1Roth IRA Basics, Investopedia, https://www.investopedia.com/terms/r/rothira.asp
2 Federal Student Aid, studentaid.gov, https://studentaid.gov/apply-for-aid/fafsa/filling-out/dependency
This article was prepared by WriterAccess.
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