Saving for College via Roth IRAs
Last updated 4th Oct 2022
Saving for college is an enormous financial undertaking, and rivals the burden of saving for retirement. These two financial challenges have something in common too: It's possible to use a Roth IRA to save for college. In fact, it's possible to use a Traditional IRA to help pay for college expenses too. For some taxpayers, using an individual retirement account as a college fund makes a lot of sense.
College Savings Accounts
Everyone's familiar with more traditional accounts like 529 plans and Coverdell IRAs. The very reason these types of accounts were created was to help pay for college-related expenses. But savers do have options; the tax law as administered by the IRS is quite flexible when it comes to using an IRA to pay for college.
Retirement Plan ExampleLet's say Bill has a pension where he works, and he's been fully participating in his employer's 401(k) plan for years. To sum things up, Bill's pretty comfortable with the money he has saved for his retirement years. But being the ultimate financial planner, Bill even has some money placed in a Roth or a Traditional IRA. Since he's comfortable with his retirement planning strategy, his focus is now shifting to paying for college. The good news is Bill has several options when it comes to how he's going to use those IRAs; including the ability to use the money to pay for college expenses.
IRA Withdrawal RulesThe reason it's possible to use an IRA to pay for college has to do with the fairly generous exception rules when making an IRA withdrawal before age 59 1/2. Some of the early withdrawal exceptions for Roth IRAs include:
- The individual is disabled
- The distribution is used to pay certain qualified first-time homebuyer expenses
- The distributions are part of a series of substantially equal payments
- The individual has significant unreimbursed medical expenses
- The distributions are not more than the individual's qualified higher education expenses, which would include college / university costs
Qualified Higher Education ExpensesFor purposes of avoiding tax penalties, qualified higher education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. An eligible educational institution is defined as any college, university, vocational school, or other postsecondary educational institution that is eligible to participate in a student aid program administered by the Department of Education. This definition includes nearly all accredited public, nonprofit, and privately owned / profit-making postsecondary institutions. In addition, account owners are not limited to their children when it comes to paying for college with an IRA. The tax law says eligible individuals include the accountholder, their spouse, their children, their spouse's children, grandchildren, or the spouse's grandchildren.
Benefits of Using an IRA to Pay for CollegeAll of the government sponsored college savings plans provide very generous income tax benefits. The same holds true for Traditional and Roth IRAs. That is, if the taxpayer qualifies, all of these accounts grow either on a tax-deferred or tax-free basis. But there are several other benefits to using an IRA to save for college. Under current law, it's possible to shelter retirement accounts when applying for financial aid. This means these funds are not viewed as an account that can be used to pay for college. The second benefit has to do with asset control. If a child decides to leave college, or not attend school, the money is used to pay for expenses in retirement. Anyone that likes the idea of using a Roth IRA, or setting up a Traditional IRA, to pay for college needs to move quickly. In addition to the withdrawal exceptions noted above, accountholders need to hold the IRA for at least five years before withdrawing funds.
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