Using Retirement Plan Assets for Education

As the school year winds down, many graduating high-school seniors are looking ahead to the promise of a new day come next fall, but for many parents, that day is fraught with mixed emotions—and a handful of college bills. To help pay for college, some parents will set aside money using more traditional ways to save for college expenses. Each has its own set of pros and cons and seldom are parents able to save enough to pay for their student’s entire education. As such, many students will require student loans in order to continue their education. The result is an average student loan debt of just under $30,000.

To help reduce the need for debt, parents (and students) may want to consider how retirement assets can be used to help pay for college expenses. While it may not be the first place to go to put Junior through school, the IRS provides certain tax breaks for taxpayers that use retirement assets to pay for qualified higher education expenses.

What are the tax benefits of using a traditional IRA to pay for education?

Under normal circumstances, when you take money out of a traditional IRA prior to age 59½, you incur a 10% penalty tax for early withdrawal. However, the IRS offers an exception when money is used to pay for education. IRA owners may withdraw up to to but not more than the amount of qualified higher education expenses incurred during the year without penalty, regardless of age. Even though the funds are not subject to the penalty, they are still subject to income taxes.

What are qualified higher education expenses for purposes of this rule?

According to chapter 9 of IRS publication 970, qualified higher education expenses include:

“[T]uition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

Does it make a difference if I use a Roth IRA?

Not really, although it is important to understand the ordering rules that apply to Roth IRA distributions. Under these rules, distributions from a Roth IRA occur first from contributions so basically any money you put in comes out first. Since money you put into a Roth IRA has already been taxed, when you take this money out it, is not subject to taxes or penalties. Once you begin distributing earnings, the exception to the penalty will apply to qualified education expenses as described above.

Is there a limit to how much I may withdraw without penalty?

Yes. You may withdraw up to but not more than the amount of qualified higher education expenses incurred during the year. Unlike the first-time home buyer exception, there is no lifetime limit on the amount an IRA owner may withdraw for qualified higher education expenses.

Do I get the same benefits with my employer-sponsored retirement plan?

Not really. The only way to tap money in your employer-sponsored retirement plan (e.g. 401(k)) for education while you are working is through a plan loan or hardship withdrawal. Plan loans are not subject to taxes and penalties—as long as you don’t default—but generally have to be paid back within five years. Also, if you leave work before paying off the loan, most plans require you to pay off the balance within a few months of separation or risk defaulting on the outstanding balance.

By contrast, hardship withdrawals from traditional retirement accounts are always taxable and may be subject to penalties if taken before age 59½. Withdrawals from Roth accounts may also be taxed and penalized depending on what amount, if any, is attributable to earnings, as well as the age of the account holder at the time of withdrawal. If you intend to use your employer-sponsored retirement plan assets to help pay for education, you may want to roll them over to an IRA after separation as the distribution rules for IRAs are generally more favorable than those of employer-sponsored retirement plans.

Is it a good idea to use retirement assets to pay for higher education?

That depends on who you ask. Many financial professionals prefer not to use retirement assets to pay for education because of the detrimental impact it may have on the account owner’s ability to achieve a comfortable retirement. You sometimes hear planners quip, “you can borrow money for college but you can’t borrow money for retirement.”

On the other hand, some investors prefer to save for education in a Roth IRA knowing that if and when they need the money for education, they can pull out their principal without tax or penalty. If the student goes to college, the earnings are left in the account to grow tax free. If the student chooses NOT to go to college, then the investor has that much more toward their retirement goal.

I suppose like all financial decisions it just depends on your specific facts and circumstances. You should weigh your options carefully before deciding whether or not to use retirement assets to help pay for your student’s higher education. Just make sure your decision is an informed one.

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