Published: June 2014
When most people think of IRAs, they probably imagine a retirement savings tool (after all, IRA is short for individual retirement account). But IRAs can enable some savers to plan for future educational costs, such as a child's college education. Consider these pros and cons when determining whether an IRA is the right choice for your family's college savings.
Usually, distributions from a traditional IRA before age 59 1/2 carry a 10 percent penalty, according to the Internal Revenue Service. But, lesser-known provisions of IRAs allow for penalty-free early withdrawal for qualifying college educational expenses, such as paying for college, books, and related fees, the IRS says. This can offer younger parents - or individuals self-financing educations - another savings vehicle to help pay for college costs.
Though both Roth and traditional IRAs qualify for exemptions from the 10 percent penalty for qualifying educational expenses, there are some differences between the two.
Distributions taken from a traditional IRA are taxed as income during the year they're withdrawn. So while you won't pay the penalty, you'll likely pay taxes on the distribution, says FinAid.org.
Roth IRA contributions, on the other hand, are made on an after-tax basis, so you can make certain withdrawals tax-free. Just make sure that withdrawals are made from your contributions - what you've paid into the account - since you'll have to pay income tax on any investment gains, says FinAid.org.
Any funds left over in your IRA (traditional or Roth) after paying for college costs can be applied toward retirement, says FinAid.org. This versatility may make an IRA an attractive investment vehicle for college savings. But IRAs do face annual contribution limits, which means you may not be able to save as much as you need for both college costs and retirement in a single account.
While a 529 plan allows for tax-free contribution limits of $14,000 per year, contributions to IRAs are capped at much lower levels. (The IRS allows contributions up to the total cost of qualifying educational expenses, but anything over $14,000 per year is subject to a gift tax). According to the IRS, most working adults may only contribute up to $5,500 per year to any IRA plan; individuals over 60 may contribute up to $6,000.
The relatively small size of permitted annual IRA contributions means you should consider saving early to finance a child's education. If you expect to have significant college expenses - such as private educations or multiple kids attending college - these contributions may not suffice.
High-income earners wishing to use an IRA for college savings face another restriction: The IRS notes that contributions are limited for single filers earning more than $114,000 per year ($181,000 married) and completely eliminated for those making over $129,000 per year ($191,000 married). See IRS Publication 590 to calculate your IRA contribution eligibility by income.
According to the IRS, Roth IRA contributions aren't tax deductible. By contrast, employees not covered by a retirement plan at work can deduct their full traditional IRA contribution on their federal taxes. This deduction may be limited if you or your spouse are covered by a work retirement plan, such as a 401(k).
According to Kiplinger.com, retirement vehicles such as IRAs are not counted as assets for federal student aid purposes. This is significant, since parental assets are used to calculate the expected family contribution for federal aid.
But traditional IRA contributions made during the previous tax year may count as income, lowering that year's financial aid eligibility, says FinAid.org. Distributions withdrawn during the current year also count as income for financial aid purposes.
Neither of these caveats apply to post-tax retirement contributions, such as those made to Roth IRA plans. Consult the Free Application for Federal Student Aid for more information.
Though Roth and traditional IRAs come with some caveats and limitations, they can also provide some tax savings and flexibility advantages for college savings. Consider your family's college budget, overall financial picture and needs prior to deciding which - if any - are right for you.
Talk to an Allstate Agent to learn more about college savings options.