Using Roth IRA to pay college expenses



Dear Joe, I have a Roth IRA that I would like to use to pay for my son's college expenses. Can I do this? What is the time frame for having the money in the Roth before you pull it out? Also, could I actually cash it in to pay for my older son's student loan and not be penalized? -- Sonya


Dear Sonya,

Yes, you can tap your Roth IRA to pay for your son's college expenses, but it may not be your best option. One reason is that you'll have to pay close attention to the income-tax rules in order to avoid taxes and penalties. Another is that distributions from your Roth IRA can have a big impact on your son's eligibility for financial aid. I explain this in more detail below.

The Roth IRA is a terrific investment vehicle. Your contributions to the account can be distributed tax-free at any time, for any purpose. And the earnings can be distributed tax-free after you reach age 59½, provided the first Roth IRA account you opened was established more than five years before. The ordering rule in Roth IRAs is that earnings come out only after you've withdrawn all your contributions, making it possible for you to withdraw contributions for college and leave the earnings in the account to grow tax-free for your retirement.

But if your Roth IRA withdrawals exceed your contributions and dip into earnings, those earnings will be taxable unless you have a qualifying event. Other than reaching age 59½, the only qualifying events have to do with your death, disability or first-time home purchase. Paying for college is not among these qualifying events, making the use of your Roth IRA for this purpose potentially subject to taxation.

Distributions from a Roth IRA that are taxable are normally subject to an additional 10-percent tax penalty. This is where college can help you. The penalty is waived to the extent you pay qualified higher education expenses, or QHEE, for yourself, your spouse or your child or grandchild. QHEE includes tuition at most accredited, post-secondary institutions, along with mandatory fees, books, supplies, equipment, room and board (see IRS Publication 970 for limits), and certain additional expenses if the student is a special-needs beneficiary.

QHEE does not include repayment of student loans, as much as I wish it would. This limitation will probably foil any plans you have to use the Roth IRA to pay off your older son's student loans.

Let's turn now to the financial-aid concern. In determining eligibility for federal financial aid, a Roth IRA is not counted as an asset of the student or the parent. That's great news, until you consider that the aid formula considers income as well as assets, and that Roth IRA withdrawals are counted as income whether or not they are subject to income tax. Even the tax-free return of your Roth IRA contributions is treated as income in the financial aid formula, and up to 47 percent of parental income will be deemed available to pay for college!

The bottom line is that you should be keeping your Roth IRA intact if withdrawing it for college creates a tax or financial-aid disadvantage. Even if there are no immediate negative consequences, you'll probably be better off looking for loans or other ways to pay for college. That way, your Roth IRA will stay fully loaded, allowing you to take full advantage of its tax benefits. After all, your son can borrow for his education, but you can't borrow for retirement.