Tapping Retirement Funds to Pay for College

Financial planners don't consider it a great idea, but parents can now tap into individual retirement accounts to help pay for college.

Rules governing both traditional IRAs and the newer Roth IRAs have been amended to allow withdrawals for qualified higher education expenses. The money can go toward college for you, your children, or grandchildren.

The main benefit: Assuming you're under the age of 59½, you won't have to pay a 10% penalty for taking a premature distribution from the IRA. You will have to pay taxes on the distribution, but the rules are different depending on what kind of account you're accessing. With the traditional IRA, the full amount of the withdrawal will be taxed when you're under 59½, assuming all your contributions were made on a pre-tax basis. If you have made after-tax contributions to your IRA, a formula is applied to determine the taxable portion of your withdrawal.

With the Roth IRA, if you're over 59½, the distribution is tax-free. Under that age, only the earnings portion of the withdrawal is taxed. Here's an example: Say you've put $5,000 into a Roth, it grows to $10,000, and then you take out $6,000 for college. The government only takes its share from the last $1,000 of that amount, because you already paid taxes on the $5,000 you contributed.

Many companies also offer alternatives through 401(k) retirement plans. These include early distributions, which incur taxes and penalties similar to traditional IRAs, or loans, in which the interest you pay goes back into your account.

In any case, many financial planners advise against borrowing or taking from tomorrow's investments to pay for college today. Parents and other account owners risk greatly diminishing their retirement nest egg by forfeiting taxes and possible future gains from their investments. That violates the cardinal rule of tax-sheltered accounts like IRAs, planners say.

The general rule of thumb is, keep deferred investments deferred as long as possibleto let compound interest work its magic.

Planners also remind their clients that there are more effective investments available for college, such as the new Section 529 plans. Those allow almost unlimited annual contributions (account maximums can be up to $250,000 per beneficiary in many states), whereas the IRAs are limited to $5,000 a year. Education Savings Accounts are even more restrictive, although annual contributions have increased to $2,000.

Deciding whether to use IRA money for college depends largely on an individual's goals. Some parents consider a college education for their children the best possible use for their investments. Others feel they just can't get college paid for without the IRA.

Parents should try to identify their goals. Do you expect to pay 100% of tuition, room and board, and other fees? Or have you considered applying for financial aid and money from student jobs?

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