Families or individuals sometimes want to tap retirement assets in an Individual Retirement Account (or IRA) to pay for educational expenses. This has become even more attractive recently, as the rules governing both traditional IRAs and Roth IRAs have been changed to allow withdrawals for qualified higher education expenses.
The tax treatment of the funds used to pay for college varies based on whether the assets being used for college expenses are in a Roth IRA or a traditional IRA. But as long as the amount of the withdrawal does not exceed the cost of higher education costs for that year, the withdrawal will avoid the 10% additional penalty.
Higher education costs are defined as any postsecondary education that is eligible to participate in student aid by the U.S. Department of Education, along with the tuition, fees, books and supplies that come with attending.
The Difference Between Using Roth or Traditional IRA Funds
With a Roth IRA, the principal portion, or amount you put in, can be withdrawn tax-free and penalty-free at any time for any purpose. A key benefit of Roth IRAs is that distributions are not taxed as earnings until the entire principal balance is withdrawn. That means you can take out as much as you put in, tax-free, to pay for college and withdraw the earnings portion tax-free when you turn 59-and-a-half.
By way of example, imagine having $100,000 in a Roth IRA on your child’s first day of college, $65,000 of which is principal and $35,000 of which represents earnings over the period that you have been contributing to the Roth IRA. You would be free to use that entire $65,000 towards college expenses before needing to worry about any tax consequences. And then you would still have $35,000 remaining that could be used for retirement purposes.
Note, however, that any withdrawals that exceed the total contributions are attributable to earnings and will be taxable for those under age 59-and-a-half. Therefore, if you withdraw $75,000 of the $100,000 from the example above to pay for college expenses and you are under 59-and-a-half, then the $10,000 of earnings withdrawn would be taxed as ordinary income on the following year’s tax return.
In the event you choose to withdraw moneys from a traditional IRA to pay college expenses, the full amount of the withdrawal will be taxed as ordinary income, assuming that you are under 59-and-a-half and that all your contributions to the traditional IRA were made on a pre-tax basis.
To use the same example from above, imagine you have contributed $100,000 to a traditional IRA. Whatever amount you take out of the IRA to pay for college expenses is taxable, no matter whether you take out $10 or the full $100,000 in the IRA. Therefore, whatever amount you withdraw will be taxed as ordinary income on the following year’s tax return.
When it’s time to prepare your taxes, any amount that you withdraw from a Roth or traditional IRA will be documented to you from the custodian on a 1099R, and are required to be reported on Form 5329 with your tax return.
Know the Tax Implications Up Front
Tapping retirement assets to pay for college expenses can provide an alternative to taking out costly student loans or paying college expenses in cash. You should ensure, however, that you understand up front what the tax implications will be, so you can avoid an unexpected, and most likely hefty, tax bill. If you do intend to withdraw assets from a traditional IRA or amounts in excess of your contributions to a Roth IRA, then consider either making quarterly estimated tax payments or adjusting your withholding to account for these distributions.
Another consideration from a planning perspective is that the $5,500 (for those under 50) or $6,500 (for those over 50) IRA contribution limits apply, no matter whether you plan to use moneys in an IRA for retirement purposes or to pay for college expenses. Therefore, if you decide you like the thought of using an IRA to save for college, make sure to factor the IRA contribution limits into your planning.
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