Early, penalty-free tapping of IRA for college

By: Savingforcollege.com

Q:

Dear Joe, Is it true that you are able to use money from an IRA to pay for college costs without the penalty or having to repay? If so, is there a specific way to go about this? Are there forms to fill out, etc.? Or do you just take out the money? What documentation is needed? Any other information regarding this area would be extremely helpful. Thank you for your time and assistance. -- Angela

A:

Dear Angela,

Yes, you can avoid the 10-percent tax penalty on early distributions from an IRA when you are paying qualified higher education expenses for yourself or for your spouse, child or grandchild. It's not necessary that the child or grandchild be your dependent. And unlike a 401(k) loan, you won't have the obligation -- or opportunity -- to repay your IRA.

The waiver applies to the penalty only and not to any tax owed on a traditional IRA distribution. (Of course, with a Roth IRA you can withdraw your regular contributions without tax or penalty at any time and for any purpose.) The optimal approach would be to leave any earnings accumulating in the Roth IRA until after you reach age 59½ and can withdraw them free from tax or penalty.

It is generally not a good idea to withdraw from an IRA if you or your child will be applying for federal financial aid in the following year. All IRA distributions, including taxed and untaxed portions, must be included in base-year income and will reduce aid eligibility. You may be much better off taking out an education loan and repaying the loan after the last financial aid application is filed.

To claim the penalty waiver, you must file Form 5329 with your Form 1040 and indicate the amount of qualifying higher education expenses incurred during the year. You don't have the use the IRA dollars directly to pay college expenses. For example, you will not owe the penalty if you pay $10,000 for qualifying expenses in January and withdraw $10,000 (or less) from your IRA in September of the same year. Refer to IRS Publication 970 for the specific categories of expenses that qualify for this exception and for the adjustment that must be made when you claim certain other education tax benefits. Keep documentation of your expenses so you can prove them to the IRS in the event of an examination.

And remember, raiding your IRA for college means it will not be there for you in retirement. Give some consideration to your other options for funding college.

Popular Questions

Question

Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Question

Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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