Last Modified on October 7, 2019

Individual Retirement Accounts (IRA) and 529 plans or education savings account (ESA) are always kept on the far ends of the financial planning spectrum. While IRAs and 401 (k)s are a common investment tool for retirement planning, 529 plans and ESAs are considered the obvious choice for education funds. In this article, we are going to break some of the biggest myths of financial planning and talk about how these two branches of financial planning can indeed intersect. 

Using an IRA to pay for education expenses

Under normal circumstances, an IRA is used for retirement expenses only. And if you withdraw the funds before the age of 59½, you are liable to pay a 10% penalty. This penalty is over and above the income tax that you will have to pay on your IRA withdrawal. But as per Internal Revenue Service’s (IRA) rules, there are some exceptions to this rule. Here are some things to note: 

1. If you want to avoid penalties, the withdrawal can only be used for certain qualifying expenses. For example, you can withdraw funds from an IRA for the down payment of a new home or for higher education expenses. However, keep in mind that you will still pay income tax on your withdrawals regardless of what you use it for.
   
2. Another important thing to note is that these expenses can only be used for your own education or for your spouse, children, or grandchildren. It is mandatory for the student to be enrolled for more than half-time at an eligible institution that falls under the Department of Education. Funds from an IRA can also only be used to pay for books, tuition fees, or other similar education expenses.
   
3. The funds from IRA can only be used towards higher education or college. You cannot make withdrawals for primary or secondary school, starting from kindergarten to 12th grade.
   
4. An important criterion to be eligible to use an IRA is that the account needs to be set up for a minimum of 5 years before you can make a withdrawal.
5. Although IRA withdrawals may seem like a great option, they can affect a student’s financial aid. Typically, an IRA is exempt from being evaluated on the Free Application for Federal Student Aid or FAFSA. However, when you withdraw your IRA funds for higher education, they are counted as your income in that particular financial year. This ultimately impacts your financial aid.
   

Difference between traditional IRA and Roth IRA

A traditional IRA is an account where you contribute money before paying income tax, whereas your contributions towards a Roth IRA are made after paying income tax. 

Both Roth IRA and traditional IRA offer the option of early withdrawals for higher education, without incurring a 10% penalty, but there are some differences between the two.

Traditional IRA

Since this is a tax-deferred account, the withdrawals are subjected to normal income tax. Traditional IRA withdrawals are also added to your yearly income and can put you on a higher tax bracket than usual. You should discuss this outcome with a financial advisor to know which tax bracket you may fall in after withdrawing money. 

Another thing to note is that the amount that you withdraw from a traditional IRA cannot exceed the amount of your education expenses. While there is no penalty on qualified withdrawals, if you withdraw extra money that is not spent on education expenses, you will incur a 10% penalty on the excess amount. 

Roth IRA

All contribution withdrawals (not earnings) from a Roth IRA are tax- free as long as the account has been set up for at least 5 years. However, if the account holder is older than 59½, then withdrawals of both, the earnings as well as the contributions, are tax-free. This is a great option for people older than 59½. 

If you don’t have either of the two IRAs, you can also roll a 401(k) into an IRA and then use the funds towards higher education. However, remember to deposit your 401(k) funds within 60 days of cashing them in, otherwise you can incur hefty penalties.

Things to do if you withdraw IRA funds

If you choose to withdraw your IRA funds, you need to file taxes on distributions. This implies that when you file taxes, you need to fill out a separate form, no. 5329, to report your distribution. This will get you a higher education exception. 

Using an education IRA

Unlike a traditional IRA, an education IRA is a tax advanced account specifically meant for higher education. The account is commonly referred to as Coverdell Education Savings Account or ESA. ESAs are one of the best and most common methods of savings for higher education expenses. Here are some important components of an Education IRA:

1. Education IRAs are similar to Roth IRAs. They are both tax- deferred accounts and allow investments to grow tax-free. The withdrawals from both these accounts are tax-free as well. 
2. You can only fund an ESA until the beneficiary is 18 years old. 
3. The funds from ESA are primarily meant for college expenses. However, you can also choose to use them for other expenses. 
4. Since ESA withdrawals are not considered an income, they don’t have any effect on a student’s financial aid via FAFSA. 
5. ESA must be used before the beneficiary turns 30 years old, or else they can be incurred with hefty penalties and tax implications. 

To sum it up 

While tapping into an IRA may seem like a great option, it should only be considered as a last resort. That’s because IRA may help in covering education costs, but it can negatively affect your retirement goals. Unless you have a considerable amount of time left to make up for the withdrawals, or a significant amount of money saved up in other retirement accounts, you should avoid taking this road. 

Are you thinking about using your IRA for education expenses? Consult financial advisors to understand how your decision can impact you in the future.