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COLLEGE SAVINGS 101

Spending your IRA on child's college

09/23/2009

QUESTION:
Dear Joe,

If I use a small IRA to pay my son's college, which isn't quite enough to pay for the rest of what he owes, will it affect his financial aid? We will need to take out another loan for the remainder of this year but we're hoping to lessen the amount of that loan by using my IRA. However, I don't want to mess up the grant money he is getting. Help! Thanks.
-- Cindy

ANSWER:
Dear Cindy,

I'm afraid your idea could backfire. Although tapping your IRA will not change what your son receives in need-based financial aid for this school year, it can affect next year's aid award.

Gross IRA distributions from the prior year are reportable as income on your son's Free Application for Federal Student Aid, or FAFSA, even when none or only some of those distributions were taxed on your Form 1040. As much as 47 percent of the FAFSA-reported income is added to the student's expected family contribution, or EFC. Higher EFC translates into lower need-based aid awards.

For example, a $10,000 distribution from your IRA in 2009 would cause a reduction of up to $4,700 in your son's need-based federal financial aid eligibility for the 2010-2011 school year. The actual amount would be less if your income level put you in a lower FAFSA bracket.

Furthermore, using a Roth IRA to pay college expenses can spoil its primary income-tax advantage. Distributions of earnings from a Roth IRA after age 59 are generally tax-free, whereas before age 59 they are taxable. Fortunately, earnings come out of a Roth IRA only after all tax-free principal has been distributed. You may escape the usual 10 percent early distribution penalty by applying the special exception for IRA distributions used to pay qualified higher education expenses.

The calculation of EFC does not count the value of your IRA. So if you keep the IRA until your son has filed his final FAFSA, his financial aid eligibility will not be affected even if you then tap it to help pay for his senior year.

To minimize your son's EFC and thereby maximize a financial aid award, look first to spend down his own investment assets, which are assessed at a high rate -- 20 percent of their value -- in the financial aid formula. Alternatively, convert those investments into a 529 plan or Coverdell education savings account, which is assessed at the parents' rate of only 5.6 percent. Either way, be sure to consider any income tax and financial aid consequences if selling those investments will cause capital gains to be reported.

To the extent you and your son ultimately have to take out loans, take full advantage of low-cost federal loans. Also check the rules for deducting interest expenses on education loans by reading Publication 970.

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