Brad Tinnon

Brad Tinnon

Using An IRA To Pay For College

Did you know that using an IRA to pay for college is allowed and is exempt from the 10% early withdrawal penalty? But the real question is whether or not you should use the IRA in the first place.

Perhaps you didn’t initially save for your children’s college education, but now you’re at a point in life where you want to cover some or all of the cost. Or perhaps you’re at that stage in life where you desire to make a career change and go back to college. Regardless of the situation, the IRA is a tool that you can use to pay for college expenses. In today’s blog post, I will discuss the rules as well as the advantages and disadvantages of using an IRA to fund college costs. In addition, I will go over alternatives strategies that you can use.

10% PENALTY

Normally withdrawing from an IRA prior to age 59 1/2 would subject the withdrawal to a 10% penalty. However, the IRS allows withdrawals to avoid this penalty if used for qualified higher education expenses at an eligible educational institution. It is important to note that 401(k)’s are not afforded this same luxury. In fact, IRAs have significantly more advantages than 401k plans which is why we usually recommend that a person rollover their 401k to an IRA. 

WHAT ARE QUALIFIED HIGHER EDUCATION EXPENSES?

The IRS defines qualified higher education expenses as tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Room and board are also considered qualified expenses if the student is enrolled at least half-time.

WHAT IS AN ELIGIBLE EDUCATIONAL INSTITUTION?

An eligible educational institution is any post secondary school (i.e. college) that is eligible to participate in a student aid program administered by the US Department of Education. If the school participates in the FAFSA program for example, then it is considered eligible. If you are unsure whether a particular school is eligible, then just contact the school; they should be able to tell you. Also schools located out of the country that participate in a student aid program administered by the US Department of Education are eligible.

WHO CAN FUNDS BE USED FOR?

The funds don’t have to be used just for you. They can also be used to pay for the education of your spouse, child, adopted child, foster child, spouse’s child, or grandchild.   

BORROWING FROM PETER TO PAY PAUL

Understand that when you take money from your IRA to cover college costs you are borrowing from one goal (retirement) to fund another (education). In the technical sense you are not really borrowing, but rather “taking”. 

But with that said, your college education could result in you having a higher paying job which could allow you to more than make up for your retirement savings. 

IS A ROTH IRA EXEMPT FROM 10% PENALTY?

Yes, a Roth IRA, just like a Traditional IRA, is completely exempt from the 10% early withdrawal penalty if the money is used for qualified higher education expenses.

WHAT ABOUT INCOME TAXES?

While the 10% penalty tax may be avoided when using an IRA to pay for college, the same cannot be said for income taxes.

Traditional IRA

If your Traditional IRA was funded entirely with pre-tax money (i.e. money for which you’ve already received a tax deduction) then every amount that you withdraw to cover qualified education expenses will be taxed at your income tax bracket. Furthermore, not only could your withdrawal possibly push you into a higher tax bracket, but it would also be considered income for federal financial aid purposes and could reduce your financial aid eligibility.

If some of your Traditional IRA was funded with after-tax money, then only a portion of your withdrawal would be considered taxable income.

Roth IRA

A Roth IRA works in a much different manner. 

Any contributions or conversion assets (assets that were converted from an IRA to a Roth IRA) that you withdraw from your Roth IRA will not face income taxation. The reason is simple: these amounts were already taxed; therefore, the IRS is not going to tax you again. 

Any earnings that you withdraw from your Roth IRA (whether this is earnings from your contributions or from your converted IRA) will face income taxation even if used for higher education expenses. However, if you are at least 59 1/2 years old and any Roth IRA that you have has been around for at least five years, then the withdrawal will be tax free. Both conditions have to be met in order to avoid income tax.

ADVANTAGES OF USING AN IRA TO PAY FOR COLLEGE

– Distributions avoid the 10% penalty if used for qualified higher education expenses.

– Funds can be used for you or other family members.

– An IRA may be the only asset you have to pay for college.

– Roth IRA withdrawals would be income tax free if you are over age 59 1/2 and you have at least one Roth IRA that is five years old.

– Roth and Traditional IRA assets are not counted in determining financial aid.

DISADVANTAGES OF USING AN IRA TO PAY FOR COLLEGE

– Could jeopardize your retirement goal.

– Withdrawals from IRAs (funded with pre-tax dollars) could face income tax.

– Withdrawals from IRAs (funded with pre-tax dollars) and Roth IRAs are considered income for financial aid eligibility purposes.

– If the 10% early withdrawal penalty is waived, then you cannot also receive the American Opportunity Tax Credit, Hope Credit, or Lifetime Learning Credit. In other words, you cannot double dip.

ALTERNATIVES TO USING AN IRA

Home Equity Loan – tax deductible and not considered income. However, if you can’t afford to make a monthly payment then this won’t be a good option for you.

401k Loan – not a good option as it will eventually be taxed (if not paid off in 5 years) in full and you would face a 10% penalty if not 55 years of age or older. Using your IRA would be better as it avoids the 10% penalty.

Student Loan – tax deductible; not counted as income for financial aid purposes; may be able to defer repayment. This is a good option for a couple of reasons. First, you can leave your IRA intact and continue the tax deferral. Second, you may get a better paying job and easily be able to cover the loan payment after graduation.

529 Plan – if you have a 529, then this is by far your best option to pay for college. The 529 asset is considered an asset of the parent (even if it is for the benefit of a child) and as a result is treated favorably for financial aid purposes. Withdrawals are entirely tax free if used for a qualifying higher education expense and are not counted as income for financial aid purposes. 

Taxable Investments – this could be a better option than an IRA depending on your tax bracket. If the tax on your taxable investment is less than the IRA, then the taxable investment would likely be a better choice. This would also allow your IRA to continue to grow tax deferred which can pay tremendous dividends for you.

SHOULD YOU USE AN IRA TO FUND COLLEGE?

At the end of the day an IRA is a legitimate tool that you can use to pay for college. However, the IRA comes with some significant drawbacks such as possible income taxation, unfavorable circumstances for financial aid eligibility, and possible impact to your retirement goal. As a result, you should give some strong consideration to applying for a student loan, tapping into another investment account (preferably a 529 if you have one), or taking out a home equity loan. If neither of these options are available to you, then using an IRA to pay for college as a last resort can help you or your family achieve the all important goal of a college degree.

I would love to hear any questions, comments, or experiences you have regarding this subject. Have you ever used an IRA to fund college? Do you think that other solutions are more beneficial? What are your thoughts on using 529 accounts to fund college?

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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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