Saving For College Using Your Retirement Plans: Using Your Traditional IRA

Using Your Traditional IRA to Cover College Expenses

If you've been contributing and saving every year in your traditional Individual Retirement Account (IRA), you may already have a tidy sum socked away and earmarked for your retirement. That money may beckon to you when the bills for your child's tuition and other educational expenses begin to roll in and your savings in other areas just aren't enough to cover them all. Clearly, the temptation is great — that money is just sitting there, you don't need any of it yet for retirement purposes, and your only option may be to either take a distribution from your IRA or take a loan to pay for those pesky college expenses.

What's more, you can do it and not pay an early distribution penalty (if you plan things right). The IRS allows you to take penalty-free distributions from your traditional IRA before you turn 59 and a half years old if that distribution is used to pay qualified educational expenses, although you do, of course, have to pay the income tax on the distribution.

Before you jump in and cash out your traditional IRA, consider these questions:

• How much money will you need in order to retire and maintain your current lifestyle? Calculators that allow you to make this estimate are available on the Internet and in most money management software packages. In addition, any good financial planner should be able to help you make this calculation.
• How much money do you currently have saved in your (and your spouse's) various retirement funds, investment accounts, and so on?
• If you use part, or all, of your current retirement savings to pay for college expenses for your kids, will you still be able to save enough to adequately pay for your retirement after doing so?

Figuring Out Qualified Expenses

Maybe you're quite certain that you have more than you'll ever need and that it makes perfect sense for you to pay at least some of your student's expenses from your traditional IRA. If so, here's what you need to know to avoid paying a 10 percent penalty on your distribution:

• You may pay only for qualified higher educational expenses. Once again, these expenses include tuition, fees, books, supplies, and equipment required for enrollment at a qualified educational institution (schools qualified to participate in federal financial aid programs administered by the U.S. Department of Education). In addition, if the student attends school at least half-time, room and board paid to the school itself or as determined by the school also qualifies.
• You may only pay qualified expenses for yourself, your spouse, your children (and your spouse's children, if they are different), and your and your spouse's grandchildren.
• If your beneficiary is a special-needs student, services incurred by him or for his benefit qualify. Of course, regulations defining who is a special-needs student and what services are covered by this designation haven't been issued yet — use your best judgment when making a determination of what you think will be covered.

Calculating The Amount Of The Distribution Not Subject To The 10 Percent Penalty

If you're under age 59 and a half when you take a distribution from your traditional IRA, remember that the general rule is that you will pay income tax on one of the following:

• The full amount of the distribution if you were able to make pre-tax contributions to the account
• The income earned in the account over its lifetime if you made after-tax contributions
• An amount somewhere in the middle if some of your contributions were made pre-tax and others were made after-tax

In addition to the income tax piece, you're also liable for a 10 percent penalty because you've taken an early distribution. However, when you use all, or a part, of that distribution to pay for qualified educational expenses, you're creating an exception to this rule. And if you use a distribution from your traditional IRA to pay for only qualified expenses, the result is clear. You'll need to calculate the portion of your distribution that's taxable to you and then pay the income tax on it, but you'll escape the penalty entirely.

Calculating the income tax and penalties on an early traditional IRA distribution becomes a bit trickier when the distribution pays only a part of your student's qualified expenses. The treatment here is similar to that used for Section 529 plans and for Coverdell Education Savings Accounts, with one major difference: While you're allowed to make a reasonable determination of how you want to assign your Coverdell and Section 529 distributions, you may use a distribution from a traditional IRA only to pay for qualified educational expenses left on the table after considering any of the following:

• Tax-free Coverdell and/or Section 529 withdrawals
• Tax-free scholarships
• Tax-free, employer-provided educational assistance
• Any other tax-free payment (other than a gift or bequest) that your student receives due to enrollment at a particular institution, such as veteran's benefits, AmeriCorps benefits, and the like

If your student receives payments or credits from these sources equal to or in excess of the total amount of their qualifying expenses, all of your traditional IRA distribution will be subject to the 10 percent penalty. If the IRA distribution partially exceeds the adjusted qualifying expenses, only that part that is in excess will be assessed the penalty.

For example, Julia's annual qualifying educational expenses at her university are currently $30,000 per year, and she expects that the total cost, including all nonqualifying expenses such as insurance and transportation, will be $35,000. This year, she's been extremely fortunate, and the university has given her a $5,000 scholarship. In addition, her mother's employer gives her a $1,000 scholarship. However, Julia's parents were late in starting a 529 plan for her benefit, so there is only $15,000 left in that account, and her parents distribute the full amount to cover part of her current expenses. Now, she has $21,000 towards the total $30,000 qualifying amount. To make up the funding gap, Julia's father has an old IRA account which doesn't play a huge role in his retirement planning, so he decides to cash it in to come up with the remaining $14,000 that Julia will need to pay her expenses, both qualifying and non, for the current year.

On the basis of these numbers, Julia's family will face the following tax consequences:

• Julia will pay no tax on the $15,000 Section 529 distribution, as the full amount of the distribution is used to pay for qualifying educational expenses, nor will she pay any tax on the $5,000 university scholarship or the $1,000 scholarship from her mother's employer.
• Julia's parents will pay income tax only on $9,000 of the total $14,000 IRA distribution, since that is the amount left on the table after all other tax-free sources of income were considered.
• Julia's parents will pay both income tax and a 10 percent penalty on the remaining $5,000 of the IRA distribution, since even though that money was used to pay Julia's expenses, those expenses were not qualified educational expenses.