The cost of living has been rising, and college tuition is no different. With that harsh reality, folks have had to find creative ways to fund their beloved offspring’s expensive hopes and dreams.
According to the US News & World Report, a “2022 Sallie Mae and Ipsos survey found that 18% of parents withdrew from their retirement savings, including a 401(k), Roth IRA or other IRA, to pay for college – up from just 6% in 2015.”
As a quick review, Individual Retirement Accounts (IRAs) often serve as the backbone of retirement savings. They provide an opportunity for regular folks to make tax-deferred investments in their quest for financial security and happiness later in life.
There are many types of IRAs but a traditional and Roth are the most common. Contributions made to a traditional IRA can be deducted from your annual tax bill, and the earnings/gains typically aren’t taxed until withdrawn for personal use. However, a required minimum withdrawal (RMD) kicks in at age seventy-two or seventy-three (please consult with your financial advisor or CPA to determine which age is right for your situation), which effectively means the tax payment is forced upon you at that point.
A Roth IRA can provide more bang for your buck when used correctly. With a Roth IRA, contributions are made from your after-tax earnings, grow tax free, and you can withdraw from your account without having to pay any taxes after the age of 59 ½. Of note, you cannot withdraw funds tax free until it’s been at least 5 years since you first contributed to the Roth IRA. Unlike RMD’s from traditional IRA’s, no distributions are ever required from the original account holder! As a side note, there can be distribution requirements from an inherited Roth IRA, so please consult with your financial advisor or tax professional if that situation applies to you.
I recently got a question from a client who wanted to know if she could withdraw IRA funds to pay for her daughter’s college tuition without incurring any tax penalties.
The short answer is yes and no. Both traditional and Roth IRAs allow you to withdraw money for qualified higher education expenses before the age of 59 ½ without incurring the 10 percent early withdrawal penalty. These expenses can be used for you, your spouse, children, or grandchildren, including tuition, fees, books, supplies, equipment, room, and board. The student must be enrolled at least half-time.
Keep in mind that the IRS requires proof of the student’s attendance at an eligible institution, and the amount of the IRA withdrawal cannot be more than the qualifying expenses. In other words, you can’t withdraw $50,000 to pay a $30,000 tuition bill and expect to skate on those penalties. Also, remember that even though the penalty is waived, the total amount withdrawn is taxable for those using a traditional IRA.
There are potential options for those wishing to use a 401(k) or workplace retirement savings account rather than an IRA, as long as the plan allows withdrawals for current employees. When that isn’t the case, people might consider rolling their 401(k) into an IRA and going from there if their plan allows for this.
If you need to use retirement funds to pay college costs, keep in mind that it can affect the amount of financial aid offered because funds withdrawn from an IRA count as income. That means the FAFSA (Free Application for Federal Student Aid) report will essentially think you make more money than you do and assume your needs are less.
However, the FAFSA uses information from two years prior, so it would be prudent to plan accordingly and withdraw the IRA money during the student’s sophomore or junior years. However, this strategy could affect the financial aid of any younger siblings.
My mission is to help folks retire sooner and happier than they ever thought they could. A big part of that happiness is the freedom that comes from having financial stability even after the paychecks stop coming. Ideally, retirement accounts are used for retirement, and it makes me nervous to see slices cut for other purposes. However, life can be a bumpy ride. We all love our kids and want the best for them. So when that college tuition bill lands on your desk and the college fund isn’t as robust as you’d prefer, it’s nice to know a retirement fund can be a viable option, and if done correctly, additional taxes and penalties can be avoided.
This information is provided to you as a resource for informational purposes only and is not to be viewed as investment advice or recommendations. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions. The views and opinions expressed are for educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions.