Use Retirement Accounts To Pay For College?

Use Retirement Accounts To Pay For College?

When it comes to saving for college, most people think about setting up a 529 College Savings Account.  However, you can also use individual retirement accounts (traditional IRA or Roth IRA) as well as 401(k) plans to pay for most college expenses.  But you have to make sure to follow the rules carefully; otherwise you could find yourself incurring additional penalties and taxes.  And in some cases it may not be the best idea.  Here’s how to do it and what to watch out for.

First, let’s address a traditional IRA.  Ordinarily, withdrawals taken from an IRA whose owner is under age 59 ½ are subject to income taxes plus a 10% penalty on the amount withdrawn.  However, distributions used to pay for higher education expenses avoid the penalty.  You can use the funds to pay for tuition, fees, books, supplies, required equipment, and even room and board (as long as the student is enrolled at least half-time).  Even nicer, you can apply the funds for your own education or for that of your spouse, your children, or even your grandchildren.  However, you should pay the money directly to the educational institution so that you have documented evidence that the money was used for education expenses.  Writing a check to your son for his college expenses, for example – even if he subsequently pays the money over to his college – would result in an unqualified distribution and you would incur the 10% penalty

Be aware, however, that money distributed from a traditional IRA to pay for college is still taxable.  After all, the IRS gave you a tax deduction for the money you contributed to the IRA and even allowed you to defer taxes all those years it was growing.  So if, for example, you were to withdraw $10,000 from your IRA to pay for college, you’d have to pay an additional $2500 in taxes that year, assuming you were in the 25% tax bracket.  Make sure to have those funds available somewhere other than in your IRA to pay the IRS the following April.

What about using a Roth IRA?  The tax rules are more complex.  To understand them we need to make a distinction between contributions and earnings, and between Roth contributions and Roth conversions.

For Roth accounts based on contributions, there’s a five year clock that starts the first time (in your life) you make a Roth contribution.  If your first Roth contribution had been made more than five years ago, then funds withdrawn from any of your contributed Roth accounts to pay for college expenses this year will be penalty-free as well as tax free.  However, if your first Roth contribution had been made sooner than that, the withdrawal will still be penalty-free, but any earnings withdrawn will be taxed.  The good news is that the IRS considers the earnings to be the last money to be distributed (they assume the contributions are always withdrawn first).  So you still might not be taxed on the distribution depending on the amount.  For example, suppose you contributed $10K to a Roth three years ago, and the balance has now grown to $12K.  If you were to withdraw $11K to pay for college, the first $10K would be considered to be the original contributions and would not be taxed.  You’d only be taxed on the remaining $1K (which the IRS considers to be the earnings).

When it comes to Roth conversion accounts, the rules change again.  Each Roth conversion has its own five year clock, unlike Roth contribution accounts, which the IRS treats as one combined account with only one five year clock.  So if you were to withdraw funds from a Roth account that had been created via a Roth conversion, and the conversion had been made less than five years previously, part of the distribution could be taxable (as above).

How about using funds from your 401(k) plan?  Once again, the rules are different.  First, you have the option of taking out a loan from your 401(k) balance to pay for college.  Most plans allow you to borrow as much as 50% of your vested account balance up to $50K.  However, such loans must be paid back with interest within five years.  If you don’t pay back the loan in time or you lose or leave your job, the outstanding balance may be considered a distribution and taxes and penalties could be applied to it.

Using a 401(k) loan is not a bad way to pay for college because there are no taxes or penalties on the withdrawal and you will not end up having done any long-term damage to your retirement savings.  By contrast, when you utilize an IRA or a Roth for college expenses, you have permanently reduced your tax-deferred or tax-free retirement savings, which may not beneficial depending on your retirement plan.  You also have the option of making what are called hardship withdrawals from your 401(k) to pay for college expenses.  However, many plans prohibit workers from making new contributions to the 401(k) plan for at least six months after a hardship distribution, making it even more difficult to begin rebuilding your retirement nest egg.

The last factor to consider when utilizing retirement plans for college expenses is the impact of those withdrawals on any financial aid for which you might qualify.  Financial aid is another complicated topic and has partially been addressed in another blog: Best Place to Hold Your 529 Plan.

Keep in mind that just because you can utilize a retirement plan for college expenses, it doesn’t mean you should.  Be sure to discuss it first with your financial planner.  Remember that retirement accounts are designed primarily to support your retirement.

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