A lot of people are increasingly using their retirement accounts interchangeably to meet their immediate or future needs. Retirement accounts such as a traditional and Roth IRA (Individual Retirement Account) have become more popular over the past years due to the flexibility afforded by them. Both traditional and Roth IRAs are also being used by investors as an alternative to a 529 plan to meet the college expenses of their child or grandchild. Before going into detail about a traditional and Roth IRA, you must understand how they differ from each other with respect to their rules and regulations, tax implications, and more. To know more about Roth IRAs and how they could fit in your retirement saving strategies, you can also consult with a professional financial advisor who can advise you on the same.
Difference Between a Traditional IRA and Roth IRA
The major difference between a traditional IRA and a Roth IRA is that in the former you make tax-free contributions and pay tax on the withdrawals later whereas in the latter, you make after-tax contributions and can make tax-free withdrawals, provided you meet certain conditions (you must have held the Roth IRA account for a period of five years at least and be of 59.5 years of age).
Implications of Using a Traditional IRA as an Education Fund
There are certain tax implications which you must consider before considering rolling over your traditional IRA into a 529 plan such as:
- When you rollover your traditional IRA into a 529 plan, the Internal Revenue Services (IRS) treats it as an addition to your income and is taxed as such. Your withdrawals are added to your gross income for the relevant financial year and taxed as your regular income, sometimes even putting you into a higher tax bracket.
- If you make a withdrawal from your account before attaining 59.5 years of age, you would have to shell out an additional 10% penalty on withdrawals. If you are a grandfather, you may be well past this age, however, if not, then in that case you would have to pay this penalty.
- Once you have cleared your taxes and penalties, only then you can take out withdrawals towards a 529 plan.
How Can You Rollover a Traditional IRA to a 529 Plan?
You can rollover your traditional IRA into a 529 plan in the following two ways:
- If you wish to make a withdrawal from a traditional IRA before turning 59.5 years of age, you can either pay the taxes and a 10% penalty and open a 529 plan account with the remaining money.
- Alternatively, you can make a withdrawal from your IRA, pay taxes, and then claim an education exemption to avoid paying the 10% penalty. Subsequently, you can open a 529 account with the funds withdrawn from your IRA.
Do Grandparents Have Any Other Options Available to Them To Fund Their Grandchildren’s Education?
Grandparents have the following options that they can avail:
- Grandparents can utilize IRA funds towards paying college fees without having to rollover their traditional IRA account into a 529 plan. If the withdrawn IRA funds are used for expenses incurred on education such as tuition fees, cost of books, other supplies and equipment, you will be exempt from payment of any penalty.
- Grandparents can also open a 529 plan where you are afforded much greater flexibility compared to a traditional IRA account. Any withdrawals made from a 529 account are not treated as regular income, thereby, your grandchild is unaffected when applying for Free Application for Federal Student Aid (FAFSA). Further, there are free of any tax implications that usually are a part of retirement accounts. A single grandparent can contribute up to $15,000 each year per grandchild to a 529 account, should they wish to. This amount can double up to $30,000 for both grandparents. Moreover, these contributions are also exempt from gift tax. Lastly, several states offer either complete or partial income tax deductions if you contribute towards a 529 plan.
To conclude
Rolling over a retirement account into a 529 plan can be tricky due to the existing taxes and penalties in place, especially for grandparents who may be nearing retirement or are already retired, by the time their grandchild goes to college. As a grandparent you have to be careful of using your retirement savings lest it leave you financially strapped, with little money left for yourself.
Before taking up a major decision like converting your IRA into a 529 plan, consider the financial implications of your decision on your current and future financial goals and objectives. If you wish to go ahead with your decision to rollover your IRA into a 529 account, consult with a professional financial advisor to understand how best to go about doing so.
To get in touch with a fiduciary advisor who may help you understand the process of rolling over a traditional IRA into a 529 college plan, 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.