Saving for both retirement and your child’s college expenses can be a challenge. With the rising cost of college, parents and prospective students are turning to retirement funds, such as individual retirement accounts (IRAs), to help pay for school. If you’re facing hefty tuition bills, you’re generally able to take a taxable distribution — penalty-free — from your IRA before you reach age 59.5, so long as you use the funds for specific higher education expenses.
If you’re considering using an IRA to cover higher education expenses, here are five IRA withdrawal rules you need to know.
1. The Distribution Must Be Used for Qualifying Expenses
Typically, IRA withdrawals before age 59.5 result in a 10 percent early distribution penalty. This is in addition to any regular income tax due. The exceptions? A down payment on a first home or higher education expenses — both are exempt from the 10 percent early IRA distribution penalty. Do note that when using an IRA to cover an education expense, you’ll still pay income tax on the portion of the distribution that would otherwise have been subject to income tax.
To be eligible to use this IRA distribution for higher education, expenses must be for yourself, your spouse, your child or your grandchild. With these funds, you can pay for books, tuition and other qualifying higher education expenses as long as the student is enrolled more than half-time at an eligible institution, as defined by the Department of Education.
2. Roth IRAs and Traditional IRAs Follow Different Guidelines
A traditional IRA is funded by pre-tax dollars, while a Roth IRA is funded by post-tax dollars. Both traditional and Roth IRAs allow you to withdraw money for qualified higher education expenses before age 59.5 without incurring the 10 percent early withdrawal penalty.
It’s important to know that the amount of your IRA withdrawal cannot exceed the amount of your qualifying expenses. When money is withdrawn from the account to pay for college-related expenses, the entire amount withdrawn is subject to income tax. Any withdrawal over the amount for qualified higher education expenses is subject to a 10 percent penalty.
Withdrawals on the principal on a Roth IRA held for at least five years are tax-free if the earnings aren’t withdrawn. If the account holder is older than 59.5, withdrawal of both earnings and principal are entirely tax-free.
3. You Can Roll a 401(k) into an IRA to Pay for Education Expenses
If you want to use an IRA to pay for qualifying higher education expenses, you can take money from your existing 401(k) and roll it over into an IRA. However, once you cash in your 401(k), those funds must be deposited into the IRA within 60 days to avoid penalties.
4. An IRA Withdrawal Might Affect Financial Aid
Money in retirement accounts, such as an IRA, is exempt from being evaluated on the FAFSA for financial aid. Keep in mind that when you withdraw IRA funds for education expenses, the funds count as income the following year, which could impact your financial aid.
5. You Need to File Taxes on Distributions
When you file taxes, you’ll need to fill out a form, usually Form 5329, to report your distribution and note your higher education exception.
Get Professional Advice on Saving for Education
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