With the cost of tuition for college and graduate school rising, a growing proportion of families are looking to retirement accounts, such as an individual retirement account, or IRA, to pay for school.
“It’s more common these days because the price of college has gone up,” says Robert Steen, enterprise advice director for retirement and complex financial planning at USAA in Texas.
For parents or prospective students interested in using an IRA to pay for school, here are some considerations to take into account.
Rules for Using Retirement Savings to Pay for College
There are rules for using an IRA account to pay for college or graduate school that families must consider before making a withdrawal.
Before an account holder is 59 1/2 years old, withdrawals usually result in a 10% penalty, but individuals using any type of IRA to pay for higher education expenses can be exempt from this.
To be eligible to use this distribution for education, the college expenses must be for one’s self, a spouse, child or grandchild. With funds from an IRA, a parent or student can pay for what are known as qualified education expenses — tuition, fees, books, supplies and equipment required for enrollment or attendance — without facing the penalty. So long as the student is enrolled at least half time, room and board are also considered qualified higher education expenses.
The student must also be enrolled in a qualifying institution, which generally includes any accredited public, nonprofit or private, for-profit college, university, vocational school or other postsecondary educational institution, according to the IRS. The institution must also be eligible to participate in a U.S. Department of Education-administered student aid program.
Roth IRA vs. Traditional IRA to Pay for College
There are differences between using a Roth IRA and a traditional IRA for higher education expenses.
A Roth IRA is funded by post-tax dollars while a traditional IRA is funded by pretax dollars. Though both types of IRAs can be used to pay for educational expenses without facing the typical 10% penalty for early withdrawals, those who do take early distributions from a traditional IRA will still have to pay income tax on that amount.
For this reason, the Roth IRA is preferable over the traditional IRA when paying for higher education expenses, says Ann Garcia, a certified financial planner and author of The College Financial Lady blog.
“Since a Roth is after-tax money anyway, you can always take your contributions back out for any reason, and there’s no tax,” Garcia says.
However, she notes that if an individual has had the Roth IRA for less than five years and withdraws not just the principal amount contributed but also the earnings to pay for college, those earnings are taxable. In the case of a parent who has contributed $30,000 into a Roth IRA that has grown to $45,000 with earnings, for example, he or she can use up to $30,000 — the contributed amount — to pay for school expenses without any tax liabilities if five years have not yet elapsed.
Using a 401(k) to Pay for College
Individuals seeking to use a workplace retirement savings account known as a 401(k) to pay for college have options, Garcia says. But the options will depend on the specific plan and whether it allows in-service withdrawals, meaning withdrawals made while the person is still employed at the company.
“If they are, a distribution taken by a parent under age 59 1/2 would still be subject to the 10% penalty and of course the entire distribution is taxable,” she says. “Some plans allow for withdrawals to pay for college under the plan’s hardship provisions. Those are still subject to the 10% penalty and tax, and usually the parent has to prove that they have no other way to pay for college than taking a distribution from their 401(k).”
Another option families have is to roll their 401(k) into an IRA to pay for school. This is typically available to account owners after they leave the company, but some plans allow this before an individual leaves.
However, once the student or parent receives the check from cashing in on a 401(k), those funds need to be deposited into the IRA within 60 days to avoid taxes and penalties.
How an IRA Withdrawal Affects Financial Aid
One problem with using a Roth IRA to pay for college or graduate school is it may cause students to receive less financial aid.
“Students who apply for need-based financial aid are required to report income and asset information on the FAFSA,” says Rick Wilder, former director of student financial affairs at the University of Florida. The FAFSA is the Free Application for Federal Student Aid, which many schools use to determine aid awards. The form uses tax information from two years ago to determine a family’s financial need.
Money held in retirement accounts, such as a traditional or Roth IRA, is an asset exempt from being evaluated on the FAFSA for financial aid. But funds withdrawn from an IRA account will count as income and may affect a student’s financial aid two years after the withdrawal, financial advisors say.
One strategy is to withdraw and use the IRA money during the student’s junior and senior years when it will no longer be considered on the student’s FAFSA in determining financial aid eligibility, Garcia says — though doing so could also affect a student’s siblings.
529 Plan vs. IRA to Pay for College
The Roth IRA is similar to a 529 plan — which is a tax-advantaged education savings account — in that it’s a tax-deferred account and can be used as a college savings vehicle.
“529 plans’ primary advantage over Roth IRAs is using earnings tax-free for education before the account owner reaches age 59½,” Keith T. Jones and Rebecca Hamm, both certified public accountants, write in the Journal of Accountancy. “However, while many view a Roth IRA predominantly as a retirement savings product, it can also be more of a ‘save now, use later’ tool. Even those younger than 59½ can withdraw Roth contributions tax-free at any point after the five-tax-year period beginning with the first tax year in which the account owner contributed to the account.”
For example, if a parent contributes $5,000 a year into a Roth IRA for the next 10 years, up to $50,000 will be available tax- and penalty-free to fund a student’s higher education.
Unlike a 529 plan, money held in a Roth IRA isn’t used in evaluating financial aid. But an IRA withdrawal may impact a student’s financial aid in two years.
“If you’re trying to play a shelter game, it will catch up with you eventually,” Steen says, since the FAFSA looks at what’s known as prior-prior year income.
A downside of saving with a Roth IRA over a 529 plan is that the account holder is limited to set contribution levels annually. A contributor under 50 years of age can sock away only $6,000 a year into a Roth IRA, and that cap increases to $7,000 when the contributor turns 50.
While saving for college through a Roth IRA may make sense in some cases, it has its drawbacks as a primary college savings vehicle. Garcia says she advises families to avoid dipping into IRA savings to pay for college, if possible.
“I never recommend that people use an IRA for college funding, especially when you are looking at young children and the long-time horizon to paying for college,” she says. “There’s a limited number of dollars you can get into retirement accounts every year. If you’re thinking you will divide those between college and retirement, chances are really good that when retirement comes around, there won’t be enough money left in there.”
Trying to fund your education? Get tips and more in the U.S. News Paying for Collegecenter.