IRAs, obviously, are for retirement. And except in very special circumstances—say, if you’ve come into a major inheritance—the money in your retirement account ought to be off limits for any other purpose. But if your financial plan shows you really won’t need your IRA for retirement, there’s another way you could use it, even if you have not yet passed the age-59½ threshold to make penalty-free withdrawals. You could pull out cash to pay for your children’s education.
The basic rule is pretty simple. Though you’d ordinarily incur a 10% early withdrawal penalty for taking a distribution from your IRA before age 59½, that doesn’t apply if the money goes to pay qualified education expenses for you, your spouse, or any child or grandchild of you or your spouse. And for these purposes, “child” is defined rather broadly. A stepchild, a legally adopted son or daughter, or even a foster child (subject to some conditions) can qualify.
Almost any post-secondary educational expenses count for this preferential treatment. The money for tuition, fees, and books can come out of your IRA as long as it goes to an accredited college, junior college, or graduate or professional school. The school can be public or private, nonprofit or for profit. If the student is attending at least half time, room and board counts, too.
Though there’s no preordained ceiling on the educational costs an IRA withdrawal can cover, you can’t take out more than the total qualified expenses incurred during a particular tax year. You’ll also have to subtract the amount of any other tax-advantaged distributions or aid applied to school costs. This may include tax-free Coverdell distributions, the non-taxable portion of scholarships or fellowships, Pell grants, or tax-free assistance from your employer, among other things. But the amount you can withdraw without penalty won’t be reduced by payments from other sources, including your income, loans, gifts, or withdrawals from 529 college savings accounts.
The only real downside to using IRA money—again, assuming you won’t need it for retirement—is that withdrawals for education from a traditional IRA will be taxed as income. If the withdrawal comes from a Roth IRA funded with after-tax dollars, only the portion deemed to come from account earnings will be taxed. After the Roth has been in existence for five years, distributions are completely tax-free if made after age 59½.
Moreover, any tax you pay on an IRA withdrawal poses another problem. Your penalty-free distribution is capped by the amount of qualified educational expenses less any adjustments for tax-free awards. You can’t withdraw enough to generate that total amount after taxes; you can take only the amount itself. So, for example, if the expenses amount to $50,000 and you pay total federal and state taxes of 40%, that extra $20,000 will have to come from outside the IRA. If you take the entire $70,000 from your IRA, the 10% penalty applies to the $20,000, increasing your tax bill by $2,000.
Just be sure you don’t need the money to fund your retirement, and have that all figured out first in a detailed financial plan.
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