Tapping IRA for college may reduce aid

05/19/2008

QUESTION:
Dear Joe,

My wife is a retiring Air Force officer, so we will have a monthly pension of $4,000 starting in a few months. I have an IRA of $300,000 that was from a 401(k) I rolled over many years ago when I became a stay-at-home dad.

We have three kids, ages 11, 9 and 6. Can we use my IRA funds for their college education? We don't plan on a private college, so we should have enough funds left over, along with my wife's pension, to fund a stable retirement.

Thank you for helping a military family!
-- Tom

ANSWER:
Dear Tom,

Yes, the IRA money can go to pay college tuition. The withdrawals you take for your own, your spouse's, your children's or your grandchildren's qualified higher-education expenses will escape the usual 10-percent penalty on early distributions. (The threat of an early distribution penalty goes away once you reach age 59½.)

Qualified expenses include tuition, fees, books, equipment and supplies. A limited amount of room and board also qualifies.

However, penalty-free withdrawals are not the same as tax-free withdrawals. You should check the rules in IRS Publication 590 to determine whether your IRA withdrawals will have to be reported on your Form 1040.

Also, consider the impact of IRA withdrawals on your children's financial aid eligibility. The entire withdrawal from an IRA -- whether taxable or not -- must be included as income on the following year's Free Application for Federal Student Aid, or FAFSA, application.

Family income is a bigger determinant of financial aid than family assets, and taking money from an IRA can dramatically reduce your children's financial-aid awards.

For those reasons -- and also because you want retirement accounts to last for the rest of your lives -- IRAs are not the best option for college funding.

Instead, open an account for each of your children with a 529 plan and start making regular contributions. Your withdrawals will be tax-free when used to pay for the account beneficiary's qualified higher education expenses.

Financial-aid treatment is also favorable: The 529 account value is assessed at the low rate for parental assets and the tax-free distributions escape reporting altogether.

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