Do you plan on maybe using an IRA to fund college expenses? Well, there are some ways in which this can happen and you not incur a tax bill, depending on the type of IRA you have. And with recent changes in the way IRA distributions are calculated this may be a real possibility for many people who saved using IRA’s. And that change is that now the government allows for withdrawals for qualified educational expenses.
However, the tax treatment of these withdrawals will depend on the type of IRA you have and which to make the withdrawals from. For ROTH IRA’s you are always free to withdrawal the principal that you have paid in over the years for any reason. Say you have contributed $65,000 in principal to your ROTH account, and it has a balance of $100,000, that means $35,000 is considered gains on the original investment. You may withdrawal the $65,000 that was paid in principal at any time with no penalty or tax consequences. If you withdrawal over the $65,000 for a qualified educational expense then the amount over the principal will be taxed as ordinary income on your next tax return. In this instance, the best thing to do is withdrawal the principal and leave the remaining $35,000 until you reach age 59 and ½ or in other words retirement age. Then you face no penalties or taxes on the withdrawals.
Now if your IRA is a traditional one the withdrawals are taxed very differently. Unlike a ROTH, the principal was not taxed before being placed in the IRA. That means any withdrawal from a traditional IRA is always taxed as ordinary income on your next tax return. While these are still excellent vehicles to save for retirement a traditional IRA is not the best way to save for college expenses. The ROTH IRA is a better choice for that purpose provided you make the full contribution allowed each year. Otherwise, you will not accumulate enough to provide adequately for much in the way of college expenses.
So what is a qualified education expense as defined by the Department of Education. It is any expense that covers higher education costs that are defined as any postsecondary education that is eligible to participate in student aid by the US Department of Education. This could include tuition, fees, books, and supplies that come along with attending an institution of higher education.
Before you tap into any retirement assets, it is always best to know the tax implications of that withdrawal up front so you can be prepared for the taxes the following year. While a retirement account can be a nice alternative to student loans or paying cash outright, it does need to be fully understood before you could incur a large tax bill. If you make taxable withdrawals from an IRA, it is wise to make quarterly tax payments in the year you make the withdrawal, so you are not hit with a huge tax liability the following year.
Also, unlike plans designed to save specifically for college expenses such as a 529 plan IRA’s have contribution limits that need to be considered as well. For those under 50 it is $5,500 a year and for those over 50 they may contribute an additional $1,000 for a total of $6,500 a year. A 529 plan is limited to education expenses so it is very different from an IRA but there are generally no annual limitations on how much you may contribute to the plan. These plans are also flexible allowing you to change the named beneficiary at a later date. And in the worst case scenario and you contribute to the plan, and it goes unused the money will go tax deferred and if you withdrawal it for a reason other than education there is a 10% penalty. If you invested wisely, you might still come out ahead provided your investment grew more than 10% a year.
This is a short post on IRA’s and education. For more information or if you have any questions, please feel free to leave a comment or send me a message directly.
