IRAs for College

Most financial advisors suggest that parents give retirement saving more priority than college saving. After all, students can borrow money for college, but parents can't borrow money for retirement. In certain situations however, parents might consider using money from their individual retirement savings accounts to help pay for college.

Why Consider an IRA for College Saving?

Normally, IRAs are withdrawn in retirement. Early withdrawals from IRAs before age 59½ are subject to a ten percent early withdrawal penalty. But if those early withdrawals are used to pay for qualified higher education expenses, the account owner may not have to pay this penalty.

There are two types of IRAs to consider for education savings: traditional IRAs and Roth IRAs.

• Traditional IRA contributions are pretax. You do not pay taxes on deposits and earnings until the money is withdrawn. Contributions are tax deductible.
• Roth IRA contributions are post-tax. Because the money has already been taxed, you pay taxes only on the earnings—and only if you withdraw those earnings before 59½ years of age. Otherwise, withdrawals from a Roth IRA are tax-free. Contributions are not tax deductible.

Which Type Is Best for College Savings?

Financial advisors tend to recommend the Roth IRA over a traditional IRA for college savings for several reasons:

• Withdrawals of the principal on a Roth are tax-free (even before retirement), if the earnings are not withdrawn.
• If the account is open for at least five years, and the account holder is over age 59½, withdrawal of both earnings and principal are entirely tax-free.
• Grandparents can take five years to build up a Roth IRA and then withdraw the whole amount after age 59½ without penalty or tax—and without any restriction on use. If they don't need the money for retirement, they can use it to help pay for their grandchildren's college expenses.

If you have a traditional IRA, or are not eligible to open or contribute to a Roth, don't despair. You can convert a traditional IRA to a Roth IRA regardless of your income level.

Disadvantages and Restrictions

Although the money in traditional and Roth IRAs is not counted as an asset when calculating financial aid, withdrawals do count as parental income, potentially reducing financial aid eligibility.

Family income affects how much parents may contribute to an IRA, and whether or not they can even open an account.

For 2013, if you and your spouse are covered by a retirement plan at work, your deduction for contributions to a traditional IRA is reduced (phased out) if your modified AGI is $95,000–$115,000 for joint filers; $59,000–$69,000 for single filers; and $10,000 for married individuals filing separately. For Roth IRAs, the limits and phaseouts for 2013 are $112,000–$127,000 for single filers; $178,000–$188,000 for joint filers; and $10,000 for married individuals filing separately.

For 2013, if you and your spouse are not covered by a retirement plan at work, you are allowed the full deduction up to the contribution limit regardless of your income.

You May Need Tax Advice

Use of IRAs for college can get very complex. Your tax advisor is your best source for guidance, especially about rules governing

• The type of money used to invest
• How having a 401(k) or other employer retirement savings accounts affects eligibility
• The timing of withdrawals and contributions
• Withdrawals reported as income when calculating financial aid
• The use of multiple tax-free funds for the same college expenses
• The impact on taxes owed

How to Avoid the Early Withdrawal Penalty

• Withdrawals cannot be more than what is needed to cover qualified educational expenses. Qualified educational expenses include tuition, fees, books, supplies, and equipment required for enrollment at an eligible school. If the student attends half-time or more, room and board are also qualified educational expenses. (The school determines the cost of attendance, including the room and board cost.) Qualified expenses do not include repayment of student loans.
• Qualified education expenses must first be reduced by any of the following:
  • Qualified expenses covered by withdrawals from a Coverdell Education Savings Account (ESA)
  • Any tax-free educational assistance, such as a tax-free scholarship, grant, veteran's assistance, or employer assistance
• The qualified expenses must be those of the account owner, a spouse, their children or their grandchildren and payable to a school that is eligible to participate in the federal student aid program.
• The distribution must occur during the same year in which the qualified expenses are paid.

Not for Everybody

You should keep your IRA intact if withdrawing it for college creates a tax or financial aid disadvantage. As with Coverdell ESAs, IRAs should not be the sole method of saving for college.

Note: Financial information provided on this site is of a general nature and may not apply to your situation. Contact a financial or tax advisor before acting on such information.