How to use an IRA to pay for college

A dad and his son split a milkshake with two straws

Most people view IRAs as a way to save money for retirement. After all, they’re called “Individual Retirement Accounts” for a reason. But did you know that your IRA can be used for savings goals outside of retirement? Depending on the type of IRA you have, you might be able to use the funds in your account for a home purchase, as an emergency fund, or even for a college education.

Keep in mind that you shouldn’t deplete your retirement savings for education expenses. That’s because there are many other options for paying for school (loans, scholarships, grants, part- or full-time work, to name a few) that are not necessarily options for paying your expenses in retirement. Also, protect your own retirement outlook before helping someone else pay for college.

Using an IRA to pay for education expenses can be tricky. There are specific rules about how, when, and why you can withdraw from these accounts. If you withdraw too soon or you don’t use the money for qualified expenses, you could get hit with a hefty 10 percent penalty plus income taxes on the funds you withdraw.

Knowing how to use this strategy, and how to avoid steep penalties, is a must for any parent looking at savings options!

How can you use an IRA for education savings?

If you’re considering using an IRA for education savings, it may make the most sense to consider a Roth IRA in order to avoid any taxes or penalties on the distribution. That’s because you can make tax-free withdrawals of contributions from a Roth IRA account before you reach age 59 ½ (the traditional withdrawal age) without the 10 percent penalty for early withdrawal, as long as the funds are going directly to qualified education costs. For example, if you contribute $30,000 to a Roth IRA, and it grows to $50,000 over several years, you can withdraw $30,000 to pay for education expenses without paying taxes or a 10% penalty on the distribution.

You could also withdraw earnings (i.e., the amount above $30,000) without being subject to the 10 percent penalty. However, those withdrawals would be subject to income taxes.

After age 59 ½, if your Roth IRA is at least five years old, your entire withdrawal is tax-free.

Should you choose to use a traditional IRA for education expenses, you’ll end up paying federal and state income taxes on your distribution. However, as with the Roth IRA, you will not be subject to the 10 percent penalty for early withdrawal for qualified education costs.

You have several options for using a Roth IRA for education expenses. First, you can open a Roth IRA with the sole purpose of using the funds for college expenses. Second, you can roll a 401k (or a portion of your 401k) into a Roth IRA if you’d like to use a percentage of your existing retirement savings for college expenses. In a roll-over, you’ve got 60 days to deposit the funds into the new qualified retirement account before penalties kick in. Funds rolled from a 401k into a Roth IRA are considered taxable income.

Benefits of IRAs for education savings.

Using a Roth IRA for education savings has several benefits. You’ll have access to your contributions penalty-free, and your contributions grow tax-free. Using a Roth IRA leaves some wiggle-room in your savings plans. If you’re not entirely sure yet how much your children’s college education will cost, or whether or not they’re interested in higher education at all, you can use the funds for retirement, or for a possible other qualified expense, such as a house down payment, for certain medical expenses, or even to fund your own continuing education.

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Drawbacks of IRAs for education savings

Of course, as with all things in the world of personal finance, a Roth IRA isn’t a fool-proof option for education savings. There are a few drawbacks to keep in mind before pursuing this strategy.

First, reducing your retirement savings means you’ll have less in the bank to draw on in retirement. No matter how much you withdraw, you cannot replenish the account beyond the normal annual contribution limits. Just as importantly, you’ll lose the benefit of earning compound interest on that money over time.

Also, don’t forget that a withdrawal from the parents’ IRA to fund a child’s first year in college could potentially impact the amount of financial aid the child receives in the following years. The withdrawal you take is viewed as income, which could mean that federal loans, scholarships, or grants are taken away or reduced when you file your FAFSA for your student’s second year.

Additionally, a Roth IRA limits how much you can contribute each year. In 2018, the contribution limit is $5,500, or $6,500 if you’re age 50 or older. While this is a helpful amount when working toward education savings, it likely won’t cover the full bill unless you save for an extended period of time before your kids head off to college.

What’s right for your family?

A Roth IRA may be an appropriate savings option for families who want to send their kids to school, or who want to continue their own education later in life. However, they’re not always the right solution.

Using a Roth IRA to save for education might work for:

  • Families who are unsure whether their savings will go toward future education expenses, but want to get a jump on putting some money aside just in case
  • Families who have some runway before they’ll need their funds (to grow their savings based on the annual contribution limits of a Roth IRA)
  • Families who are within the Roth IRA’s contribution limits based on their Modified AGI
  • Families who have significant retirement savings elsewhere, or a plan to build them

Using a Roth IRA to save for education might not work for:

  • Families who make more than the set income limits for contributing to a Roth IRA
  • Families who don’t have enough time for their savings to grow in the Roth IRA to make withdrawals worthwhile (based on annual contribution limits)
  • Families who need to contribute a large amount in the next several years to pay for education costs (more than the $5,500 annual limit)
  • Families who have low or no other retirement savings

If you’re not sure whether or not a Roth IRA is the education savings solution you’re looking for, you might consider looking at a few other options:

  • 529 plans
  • Qualifying U.S. Savings Bonds
  • Mutual funds
  • Custodial accounts
  • Traditional cash savings

Saving for college can be stressful, but there are so many different options available to make your journey a little bit easier. When in doubt, I recommend speaking with a financial planning professional about what savings tools will fit best into your financial plan.

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Mary Beth Storjohann, CFP® and Founder of Workable Wealth, is an author, financial planner and accountability partner working to help clients in their 20s-40s across the country make smart, educated choices with their money. Her recent accolades include the “Top 40 Under 40” by Investment News, “10 young Advisors to Watch” by Financial Advisor Magazine, and “10 of the Best Personal Finance Experts on Twitter.” She frequently appears on NBC as a financial expert and her expertise has been featured in The Wall Street Journal, CNBC, Forbes and more. Opinions are her own.

Haven Life Insurance Agency offers this as educational information. Haven Life does not offer investment or tax advice and encourages you to seek advice from your own legal counsel, investment advisor, or tax professional.

Haven Term is a Term Life Insurance Policy (ICC15DTC) issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111 and offered exclusively through Haven Life Insurance Agency, LLC. Not all riders are available in all states. Our Agency license number in California is 0K71922 and in Arkansas, 100139527.

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