Earning a college degree is practically a must these days if you want to get ahead in the workforce but the cost can be a significant obstacle for many students. According to CollegeBoard, the average cost of tuition at a public four-year university was $22,203 for the 2013-14 school year. Students who attend a school pay, even more, averaging $30,094. Those figures don’t include the cost of room and board or books.
Parents who are looking for ways to save ahead for college expenses have several options to choose from, including 529 plans and Coverdell Savings Accounts. There’s also a third option–taking money from your traditional or Roth IRA. While there are some benefits to using the cash in your retirement account to pay for education there are also several drawbacks to consider. Here’s a look at the pros and cons of tapping your nest egg to pay for college.
Pro #1: No early withdrawal penalty
Generally, when you take money out of a traditional or Roth IRA before age 59 1/2, you’re automatically subject to a 10 percent early withdrawal penalty. The penalty is assessed on top of any taxes you owe on the distribution. The upside is that this penalty is waived if you’re using the money to pay for education expenses.
Under the IRS guidelines, this includes tuition, books, fees, supplies, and equipment. The exception also applies to room and board if the student is enrolled at least half-time. IRA funds can also be used to cover additional necessary expenses for special needs students. The money has to be paid to an eligible educational institution, which simply means any school that’s eligible to participate in the federal student aid program.
Pro #2: Roth IRA withdrawals may be tax-free
A Roth IRA is funded with after-tax dollars, which means that once you reach age 59 1/2, you can start withdrawing your earnings tax-free. While you won’t be able to deduct your contributions the way you would with a traditional IRA, Roth IRAs do offer a distinct advantage when it comes to early withdrawals. As long as you’re withdrawing contributions only and your account’s been open for at least 5 years, you won’t pay any income tax on the money.
Pro #3: Eligibility is flexible
Parents can use their IRA money to pay for their child’s college expenses but the IRS allows some flexibility when it comes to who is considered a qualifying student. Generally, you can use the money to pay higher education expenses for yourself, your spouse or your spouse’s children or grandchildren. That’s definitely a plus if you decide you want to go back to school or help with a stepchild’s education.
Con #1: Traditional IRA withdrawals may be taxable
The upside of saving money in a traditional IRA is that your contributions may be tax-deductible and any money you put in is allowed to grow tax-deferred. The problem with using the money to pay for college expenses is that you will owe income tax on anything you take out. If you’re pulling out a large chunk of change, it could push you into a higher tax bracket, thereby increasing your overall tax liability.
Con #2: You miss out on future earnings
Aside from the tax considerations, perhaps the biggest disadvantage of using your retirement money to pay for college is the fact that it diminishes your overall savings. While you can make new contributions, you can’t replace the earnings you would have gotten if you had left the money alone. Even if you’re only taking out a few thousand dollars, it can still have a significant impact on how much you end up with once it’s time to retire.
Figuring out the best way to pay for college expenses requires some careful planning and an assessment of where you’re at financially as well as your long-term goals. Using your IRA to cover these costs can work to your advantage but it helps to understand what the potential downsides are.