No matter if you’re saving money to pay for college for yourself or a child, it’s important to use the right account so you get as many benefits as possible. Laura answers a listener question about whether he should use an IRA or a 529 plan for the best results.
Rules for Taking Withdrawals from an IRA
You can take distributions from an IRA at any time and for any reason; however, withdrawals may be taxable and may also be subject to an additional 10% early withdrawal penalty if you’re younger the official retirement age of 59½.
Now that you understand the basics of traditional and Roth IRAs, let’s talk about the rules for taking money out of them. You can take distributions from an IRA at any time and for any reason; however, withdrawals may be taxable and may also be subject to an additional 10% early withdrawal penalty if you’re younger the official retirement age of 59½.
The good news is that there are exceptions to the 10% penalty and paying for higher education for you, your spouse, your children, or grandchildren is one of them!
But what about taxes? Well, that depends on which type of IRA you have.
With a traditional IRA you don’t pay tax upfront on contributions. So taking a withdrawal for any reason does trigger income tax. Uncle Sam makes sure you pay your share. But you get to skip the additional 10% penalty if you use the money for education expenses.
With a Roth IRA you pay tax upfront, and therefore never have to pay it again. As long as you don’t take out any of your earnings or growth in the account (which haven’t been previously taxed), you can take an early withdrawal from a Roth IRA to pay for college that’s penalty free.
For example, let’s say you have $10,000 in your Roth IRA that’s made up of $9,000 of your original contributions and $1,000 in growth. Taking out the full amount to pay for a child’s education means that you’d owe tax (but not not a 10% penalty) on $1,000.
An additional factor to consider is that taxable distributions from either type of IRA get added to your income, which could affect the next year's financial aid eligibility for your child.
See also: Your Guide to the Roth IRA
What Is a 529 Plan?
As you can see, if you plan on using funds from an IRA to pay for college, having a Roth gives you a leg up over a traditional account because you can pay less or no income tax on withdrawals. However, as I previously mentioned, if your income exceeds the allowable limit, you may be shut out of a Roth IRA.
Let’s talk about how an IRA stacks up against another great account commonly used for education expenses—a 529 college savings plan. These accounts allow you to save for college in two ways: using a prepaid plan or a savings plan.
With a 529 prepaid plan you pay for tuition at a state school ahead of time. That means you get tomorrow’s tuition at today’s prices. Since the cost of college continues to skyrocket every year, this prepayment strategy can save a lot of money.
But what if you prepay at one school and your child wants to go to a different one? Funds in a prepaid plan may be withdrawn so you can use them at an out-of-state school or a private college. However, you may not get the full value out of the plan because you’ll generally have to make up the tuition difference.
With a 529 savings plan, you invest contributions in a tax-deferred account. This is similar to a retirement account, where you choose investments from a menu of options.
Savings plans are offered by states, not schools, and they can be used at any accredited school in the country, and even at some foreign institutions. For instance, you could live in New York, participate in a Florida 529 saving plan, and use the money to pay for a school in California.