Roth IRA Can Help Pay Higher Education Expenses
by Lisa Walker, CISP, CHSP
On average, Americans spend $30,000‒$35,000 per student per year on college, according to College Board. It’s no wonder that for many people, paying for higher education can be a heavy financial burden. Chances are some of your clients are looking for ways to reduce this burden. Perhaps some are using 529 accounts (tax-deferred savings vehicles under Internal Revenue Code Section 529) to save for college on a child’s behalf. After all, a 529 account is the primary tax-advantaged way to save for education. But as the price of sending a child to college increases year after year, the expense can easily overwhelm even the most diligent 529 savers. Some of your clients may need to draw from more than their 529 accounts. They may want to consider supplementing their 529 savings with Roth IRA savings to pay for college.
Roth IRA Contributions
One of the benefits of a Roth IRA is the ability to take distributions anytime. And, as long as the IRA owner takes out what he put in as a regular contribution, those dollars are not subject to tax (including penalty tax)—no matter what the reason for the distribution or the age of the Roth IRA owner. This is a key advantage for Roth IRA owners who plan to pay for college or post-secondary school expenses for themselves or their children.
All contributions to a Roth IRA are considered after-tax assets, or basis, as those amounts were not tax deductible at the time of the contribution. Thus, they are not taxable upon withdrawal and the early distribution penalty tax does not apply.
All conversions and retirement plan rollovers to a Roth IRA are also considered after-tax assets. But if it’s been less than five years since the conversion or rollover and the Roth IRA owner does not have a “qualified distribution,” a penalty tax would apply (unless the IRA owner meets an exception). A qualified distribution means that the Roth IRA owner has had the Roth IRA for five years or more and is age 59½ or older, disabled, deceased, or a first-time homebuyer.
Any earnings in the Roth IRA that come out with a qualified distribution will not be taxed. But if part of a nonqualified distribution, earnings will be taxed and subject to penalty upon distribution, unless there is a penalty tax exception.
Penalty Tax Exception for Higher Education
A nonqualified Roth IRA distribution will not be subject to a penalty tax if one of the many early distribution penalty tax exceptions applies. One exception is for qualified higher education expenses incurred at an eligible educational institution by the IRA owner, the IRA owner’s spouse, or any child or grandchild of the IRA owner or IRA owner’s spouse.
Qualified higher education expenses generally include tuition, fees, books, supplies, computer technology, equipment required for enrollment or attendance at an eligible educational institution, special needs services for special needs students, and room and board for students enrolled at least half time. An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the U.S. Department of Education, which generally includes all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. A child is defined as a son, daughter, stepson, stepdaughter, adopted child, and eligible foster child of the taxpayer.
Roth IRA nonqualified distributions of earnings are penalty-free as long as they do not exceed the amount of qualified higher education expenses for the taxable year. And there is no dollar limit on the amount of higher education expenses that can be considered for penalty exception purposes.
This gives Roth IRA owners the flexibility to use their Roth IRA assets for more than just retirement. When paying for higher education expenses, the Roth IRA can become a trusty sidekick to the 529 account. A word of caution though: If also applying for federal student financial aid, an IRA distribution taken to pay for higher education expenses during a financial aid application year is counted as part of the student’s income and may affect financial aid eligibility.