The cost of education in America has increased dramatically over the years. To say it can be burdensome would be an understatement. The average college cost of a four-year public institution has increased by 213% in the past 30 years. If we take up recent numbers, the cost of education has gone up by 29%, with private college tuition costs climbing by 25% in the last decade alone. If you have children or grandchildren who want to go to college, it is quite likely that you would have put some thought into how you can fund their college tuition. An Individual Retirement Account (IRA) is one such option that has been gaining popularity over the last few years.
An IRA is a tax-advantaged retirement savings account that individuals can open to save and invest in the long term. You can open an IRA at any age; however, you can only contribute to it through earned income. The Internal Revenue Service (IRS) has defined earned income as any income received from a job or self-employment such as salaries, wages, business earnings, disability retirement benefits, commissions, bonuses, assignment work, etc. You can use your IRA to cover education expenses even before you reach retirement age. If you adhere to the rules specified by the IRS, you can use your retirement savings to pay for a wide range of education expenses for you, your spouse, children, or grandchildren without incurring a penalty. To learn more about how you can use an IRA to fund college tuition, reach out to a professional financial advisor who can guide you on the same.
In this article, we will cover how you can use an IRA to pay for college expenses, its benefits, how to avoid penalties, and more.
How can you use an IRA to pay for college tuition?
Typically, an IRA is used to fund your living expenses in retirement and ensure you have enough money to last your golden years. However, you can use your retirement funds for other purposes too. There are certain restrictions when it comes to withdrawing funds from your IRA account. If you withdraw money before reaching 59.5 years of age, you are liable to pay a 10% penalty. Do note that this penalty is separate from the income tax that you will have to pay on your IRA withdrawal.
However, there are some exceptions to this rule. These are:
- If you withdraw funds for purchasing a home (as a first-time homebuyer) or for funding higher education expenses, these are deemed as qualifying expenses and no penalty is levied by the IRS. However, you would still have to pay income tax on your withdrawals.
- Any funds withdrawn from an IRA can only be used for funding your own education in addition to your spouse, children, or grandchildren. The IRS mandates that the student should be enrolled at an eligible institution that falls under the student aid programs offered through the U.S. Department of Education.
- You also need to consider the impact of IRA withdrawals on student aid if you plan on applying for it. Any withdrawals made from an IRA are treated as your income in that particular financial year. This can impact your ability to apply for financial aid through Free Application for Federal Student Aid or FAFSA.
What is an education IRA?
Unlike a traditional IRA, an education IRA is a tax-advantaged investment account used for paying higher education expenses. It is also known as Coverdell Education Savings Account or ESA. Under this, parents and guardians can make contributions to an education IRA for a child under the age of 18.
Let us go through the salient features of an education IRA:
- Education IRA is similar to a Roth IRA in several aspects, chief among them, both accounts are tax-deferred in nature wherein your investments grow tax-free. You can also make tax-free withdrawals from both these accounts subject to the fulfillment of certain conditions.
- An ESA can only be funded till the time the beneficiary reaches 18 years of age.
- ESA funds are primarily meant to cover college tuition however they can be used to pay for other expenses too such as certain K-12 expenses.
- Any withdrawals made from an ESA are not deemed as income. This means that it does not affect a student’s ability to apply and benefit from financial aid such as FAFSA.
- An ESA has an annual contribution limit of $2,000. If you exceed this amount, you may attract a penalty.
- If the funds held in an ESA are not used for college, then those funds must be distributed to the child who was the intended beneficiary of the account.
- The funds held in an ESA must be completely used before the beneficiary turns 30 years old. If not, it will be subject to tax and penalties.
Can you use a Roth IRA to pay for college costs?
Yes, you can. The IRS does not restrict using Roth IRA funds for paying college expenses. Moreover, you can make tax-free withdrawals to cover the higher education costs of your child or grandchild without meeting the criteria of reaching 59.5 years of age or completing the 5-year holding period for a Roth IRA account. No penalty will be levied on you. However, you will have to pay the income tax charges as applicable on the earnings portions of the sum withdrawn by you. Further, if you only withdraw the sum contributed by you (not the earnings portion), you can enjoy tax and penalty-free distributions, if used for covering higher education expenses only. There are several benefits of using a Roth IRA for college expenses.
These are:
- Your money grows tax-free since you contribute after-tax dollars.
- You can make tax-free withdrawals if you are 59.5 years old and have held the account for a period of at least five years. However, as stated above, there is an exemption to this rule. If you withdraw funds from your Roth IRA to pay for college tuition, you do not have to pay a 10% penalty on the same.
- You can use your Roth IRA funds as you see fit without any restrictions. You can either use them to pay for your child’s education or meet any other financial need. Additionally, there is no ceiling placed on qualified education expenses for a Roth IRA. This means that the money that has not been used for funding higher education can be used to support you during retirement.
- There is greater flexibility in terms of investment options available allowing you to earn higher returns in the long run.
To conclude
Using an IRA to cover college expenses may seem like a great idea, however, it should only be used as a last option. This is because using your retirement funds to cover the tuition costs may negatively affect your retirement goals and put a big dent in your retirement savings. If you feel you do not have an alternative, ensure that you have a substantial amount of time left to make up for the withdrawals or a significant amount of funds saved up in other retirement accounts. To get a better perspective on the situation, you can try taking professional help and see what the expert has to say on the matter.
To get in touch with a fiduciary advisor who may help you understand how to use an IRA for education expenses, its benefits and drawbacks, tax implications, and more, use the free advisor match service. Based on your requirements, the platform scans through registered and qualified advisors to match you with an advisor suited to your financial needs and goals.