The avoidance of this penalty is often confused with the avoidance of income taxes, but these are two separate issues. These withdrawals will not avoid normal income tax on funds that were previously untaxed.
Who Is the Ideal IRA or Roth IRA Investor?
Investing for college in a Roth or Traditional IRA should be evaluated when a number of the following conditions are present:
A parent is sophisticated in their understanding and knowledge of tax rules. Retirement objectives are already being met sufficiently through other plans. The parents or children are eligible to contribute to an IRA. They will not get financial aid if they show any college savings. They have already maximized other college savings options or are not eligible based on their income. They will not likely need to withdraw more than their original investment. They want to retain final control over unused assets.
Advantages and Disadvantages
Perhaps the biggest potential advantage of using an IRA is that retirement plan assets are not included in most financial aid calculations. If an identical amount of money is saved in a Coverdell ESA or Section 529 account, 5.64% of its value will count against financial aid each year. Another advantage is that unused funds—if held in the IRA until normal retirement age (at least 59½)—will not be subject to a 10% withdrawal penalty. In the case of a Roth IRA, they will not be subject to income tax, either. However, there is a 10% penalty (plus income taxes) levied against unused Section 529 or Coverdell ESA funds when they are withdrawn.
Disadvantages
There are numerous disadvantages to this strategy as well. Perhaps the biggest is the loss of the use of an IRA for your annual retirement savings. Using a retirement IRA to save for college costs you the opportunity to use it to save for your future. Since retirement will be much more costly than a college education, this is a key consideration. Another disadvantage will be the taxation on withdrawn funds. In a traditional (deductible) IRA, the entire withdrawn amount will be subject to federal and state income tax. In a Roth IRA, any funds that are withdrawn above and beyond your original contributions will be taxed at the federal and state levels. When this is compared to the tax-free withdrawals permitted for Section 529 plans and Coverdell ESAs, this can represent a significant waste of money. For example, a $20,000 taxable withdrawal for qualified expenses from either type of IRA might easily cost $5,000 in taxes (assuming a 25% federal and 5% state tax rate). This same withdrawal from a Section 529 or Coverdell ESA account would be tax-free.
Investment Options and Tax Benefits
Permitted investments for IRAs include the full menu of individual stocks, bonds, CDs, and mutual funds. In addition, annuities can be purchased in IRAs, but generally should be avoided. The big advantage of any type of IRA is tax-deferred growth. In other words, you do not have to pay tax each year on the interest, income, and growth of your investments. This helps super-charge your growth rate even if you have to pay the tax later, as is the case with the traditional IRA. However, this benefit is partially lost when money is withdrawn for education expenses. Though the IRS waives the 10% penalty for early withdrawal, you are still liable for income tax on money that has never been taxed elsewhere. This would mean any money withdrawn from your deductible IRA—and any gains from a Roth IRA—would be hit with income taxes.
How Eligible Expenses Affect Financial Aid
Eligible expenses include:
Tuition at the college level or higher (room and board if at least half-time student) Books, equipment, and fees (if required by the school)
Money held in retirement accounts such as a traditional or Roth IRA does not need to be reported on the Federal FAFSA form. Thus, it will not hurt financial aid eligibility.
Contribution and Eligibility Rules
Withdrawals that avoid the 10% early withdrawal penalty must be for the education of the account owner, their spouse, children, or grandchildren. There are complex contribution rules for IRAs that are affected by the type of IRA, a contributor’s age and income, and whether or not the contributor or their spouse is offered a retirement plan by their employer. For 2022, the maximum yearly contribution to an IRA is $6,000 per person, with an additional $1,000 catch-up for account owners age 50 and over, for a total of $7,000.
Withdrawal Rules and Treatment of Unused Funds
As previously mentioned, IRA withdrawals before age 59½ may be subject to income tax and a 10% penalty. The 10% penalty is waived for qualified higher education costs, but any withdrawals of previously untaxed money are still subject to income tax no matter what. Unused funds remain the property of the parents for as long as they choose. However, traditional IRAs (not Roth IRAs) are subject to required minimum distributions (RMDs) starting at age 72.
