With the cost of tuition of college and grad school rising, more parents and prospective grad students are looking to retirements accounts, such as an individual retirement account, to pay for school.
A 2015 Sallie Mae and Ipsos survey found that 6 percent of parents withdrew from their retirement savings, either from a 401(k) or IRA, to pay for college.
“It’s more common these days because the price of college has gone up,” says Robert Steen, a Texas-based wealth advisor at USAA Federal Savings Bank.
For parents or prospective students interested in using an IRA to pay for school, here are some considerations to take into account.
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· There are rules for using an IRA account to pay for college or grad school. Withdrawals before 59.5 years of age usually result in a 10 percent penalty except in certain circumstances, such as a down payment on a first home or for higher education expenses, according to the IRS.
To be eligible to use this distribution for education, the expenses must be for yourself, a spouse, child or grandchild. With funds from an IRA, a parent or student can pay for books, tuition and other qualified education expenses without a penalty. But the student must be enrolled more than half-time at an eligible institution, as defined by the Department of Education.
· There are differences between using a Roth IRA and a traditional IRA for higher education expenses. “The best advantage would be to use a Roth IRA, which you can pull out without a 10 percent early withdrawal penalty,” says Kevin Wallace, a wealth management advisor at Janney Montgomery Scott’s headquarters in Philadelphia.
A parent or prospective grad student, for example, who has contributed $30,000 into a Roth IRA that has grown to $45,000 with earnings , can use up to $30,000 — the contributed amount — to pay for school expenses without any tax liabilities.
For the account holder to avoid penalties, the Roth IRA must have been established at least five years before the first withdrawal.
Withdrawals from a traditional IRA can also be used to pay for educational expenses, but lack the same advantage s of a Roth IRA and are subject to federal and state tax, financial experts say.
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· You can roll a 401(k) into an IRA to pay for school. Anyone can take money out of a 401(k) and deposit it into an IRA, Wallace says. The only caveat is that once the student or parent receives the check from cashing in on a 401(k), those funds need to be deposited into the IRA within 60 days.
“I have heard people look at it, but no one admits to it,” says Wallace , about young professionals cashing in their retirement accounts to pay for grad school. “They’ll roll everything out of their 401(k) into an IRA, and then they’ll take distributions out to fund their graduate school.”
· An IRA withdrawal may affect financial aid. One problem with using a Roth IRA to pay for college or grad school is it may impact financial aid.
“Students who apply for need-based financial aid are required to report income and asset information on the FAFSA,” says Rick Wilder, the director of student financial affairs at the University of Florida. The FAFSA is the Free Application for Federal Student Aid, which many schools use to determine awards.
Money held in retirement accounts, such as a traditional or Roth IRA, are assets exempt from being evaluated on the FAFSA for financial aid.
But withdrawing funds from an IRA account will count as income the following year, financial advisors say.
One strategy is to use the IRA money during the student’s final year in school when financial aid for the following year is no longer an issue, according to an investment service report released by BancWest, a San Francisco-based financial institution.
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· A 529 account may be a better option. The Roth IRA is similar to a 529 account, a tax -advantaged education savings account, in that it’s a tax-deferred account and can be used as a college savings vehicle.
If you contribute $5,000 a year into a Roth IRA for the next 10 years, up to $50,000 will be available tax- and penalty-free to fund a student’s higher education, for example.
Unlike a 529 account, money held in a Roth IRA isn’t used in evaluating financial aid. But an IRA withdraw al may impact a student’s financial aid the following year.
“If you’re trying to play a shelter game, it will catch up with you eventually,” says Steen. “It’s the following year when it captures it on the FAFSA.”
A downside of saving with a Roth IRA over a 529 college savings account is that the account holder is limited to set contribution levels annually. A contributor under 50 years of age can only sock away $5,500 a year into a Roth IRA and that cap increases to $6,500 when the contributor turns 50.
While saving for college through a Roth IRA may make sense in some cases, it has its drawbacks as a primary college savings vehicle, wealth advisors say.
A student or parent is better off using the account for its intended purposes — saving for retirement, Steen says.
Trying to fund your education? Get tips and more in the U.S. News Paying for College center.
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5 Things to Know About Using an IRA to Pay for Tuition originally appeared on usnews.com
