You might be surprised at its potential.
Provided by TechGirl Financial
An IRA is a retirement savings account, right?Indeed. IRA stands for Individual Retirement Arrangement. Even with that definition, however, there is no prohibition on using an IRA to save for other purposes, such as funding a college education.
Why would anyone choose an IRA as a college savings vehicle?At first glance it may seem strange, since there are other types of investment accounts specifically dedicated to that objective. On closer inspection, though, IRAs (especially Roth IRAs) present some features that may be quite attractive to the parent or grandparent who wants to build education savings.
Flexibility.Parents are urged to save for their children’s college education as soon as possible, but what if their children end up spending little or no time in college? Some young adults do start careers or businesses without any higher education. Others have no interest in going to school any longer. Another, more pleasant, circumstance worth mentioning: what if a child ends up getting a significant college scholarship or even a full ride?
If any of these things happen, parents or grandparents who have opened a conventional college savings account may face a dilemma. Withdrawals from such accounts are tax free as long as they are used for qualified educational expenses, but if the money is withdrawn for other purposes, the Internal Revenue Service defines the distribution as taxable income (and the account gains are subject to a 10% penalty). The account assets can often be transferred to another family member, but not all families have that option.1,2
Assets saved and invested for college in an IRA have the potential to be repurposed as retirement savings, if necessary.
Tax-deferred growth and the possibility of tax-free withdrawals.You probably know the basic distinction between a traditional IRA and a Roth IRA: the former permits tax-deductible contributions as a tradeoff for eventual taxable withdrawals, while the latter offers no tax deduction on contributions in exchange for tax-free withdrawals later (provided an investor follows I.R.S. rules). Either IRA gives you tax-deferred growth of the invested assets.3
Can you open a Roth IRA, own it for five years or more, and withdraw its assets tax free even if you use the money for something other than retirement? If that something is a college education, the answer is (a qualified) yes.3
Withdrawals from Roth (and for that matter, traditional) IRAs taken before age 59½ face no early 10% withdrawal penalties if the money withdrawn is used for qualified educational expenses. Does this mean you can take $100K out of a Roth IRA today and use it to pay for your child’s college education? Probably not that large an amount, as some restrictions apply.1
If you own a Roth IRA and are younger than 59½ (or are older than 59½, but have owned your Roth IRA for less than five years), your Roth IRA’s earnings are ordinary, taxable income if withdrawn. Roth IRAcontributionsmay be withdrawn tax free at any age. So, as a hypothetical example, if you have contributed $45,000 to a Roth IRA and followed I.R.S. rules, as much as $45,000 could be taken out of that IRA tax free and used for qualified educational expenses.3,4
Not considered an asset on the FAFSA.When students apply for college aid, they routinely fill out the Free Application for Federal Student Aid (FAFSA), which helps the federal government figure out the Expected Family Contribution (EFC), or the degree of college costs the family finances can handle. Conventional college savings accounts need to be reported as assets on the FAFSA, but IRAs and other retirement accounts do not need to be.1
What are the shortcomings of building college savings with an IRA?First, this idea may not work for retirees: you must have earned income to make IRA contributions, and you cannot make traditional IRA contributions past age 70½. Phase-outs for high earners may reduce or even prohibit annual Roth IRA contributions for some. Lastly, the annual contribution limit for Roth and traditional IRAs is currently set at $6,000 ($7,000, if a catch-up contribution is included), and that may be frustrating for a household needing to build college savings in a hurry. Even so, families who seek more flexibility in their college savings options may see an IRA, particularly a Roth IRA, as an intriguing potential savings vehicle.3
Kim Gaxiola, CFP® may be reached at 800.584.3652 or firstname.lastname@example.org.
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