Last week I came across an interesting article by Erin Arvedlund in the Philadelphia Inquirer about saving for college tuition. The article reminded me that it's possible to use a Roth IRA to pay education expenses.
Generally, if you take a distribution from an IRA before you reach age 59 1/2, you must pay a 10% additional tax on the distribution. However, distributions used to pay qualified higher education expenses for you, your spouse, your children or your grandchildren are an exception to this additional tax. Qualified higher education expenses include tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. If the student is at least a half-time student, room and board are also qualified educational expenses. An eligible educational institution is any college, university or other postsecondary educational institution eligible to participate in a student education program administered by the U.S. Department of Education.
If you are under age 59 1/2, or you have not held the Roth IRA for at least 5 years, then only the contribution portion of the Roth IRA can be withdrawn tax free. The earnings portion is subject to income tax, but not the 10% additional tax. Importantly, withdrawals are treated as a return of contributions first and as earnings second. Of course, if you are older than 59 1/2 and have held the account for more than 5 years, then all withdrawals are tax-free, regardless of what you use the money for and whether it represents a return of contributions or earnings.
The rules work like this: Assume I'm 49 years old and have a Roth IRA with a $25,000 balance in an account I've held for more than 5 years. Of the Roth IRA account balance, $15,000 represents my contributions (which I funded with after-tax dollars) and the remaining $10,000 represents the income and growth on my contributions. If I withdraw $15,000 from the account and use those funds to pay my daughter's qualified higher education expenses, no portion of the withdrawal is taxable or subject to the additional 10% tax. The $15,000 withdrawal is treated as a return of my contributions. If I withdraw the entire $25,000 and use those funds to pay qualified higher education expenses, $10,000 will be taxed, but no portion of the withdrawal will be subject to the 10% additional tax.
Roth IRAs present an interesting alternative to the college funding dilemma. If you think this is something worth exploring and you are relying on financial aid, make sure know how the withdrawal will affect your eligibility for financial aid before you make the withdrawal. For more information on education exceptions to the 10% additional tax, see this IRS publication.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
