Disadvantage of Using Your Roth IRA for Higher Education Expenses
By Joe Cicchinelli, IRA Technical Expert
Follow Me on Twitter: @JoeCiccEdSlott
While Roth IRAs should ideally be used for retirement, the fact that you have unrestricted access to your Roth IRA basis allows you to take a distribution at any time for any reason. Maybe you’re planning on going back to college or graduate school, but you don’t want to go in debt to pay for it. However, if you’re planning on using your Roth IRAs to pay for higher education expenses, there is a big disadvantage you need to know about before you do so.
All Roth accounts are considered to be one account for distribution purposes. Roth IRA distributions that represent your accumulated annual contribution funds are deemed paid out first and are always tax-free and penalty-free; regardless of how old you are when you take it out or for what you use the money.
After all your Roth contribution funds have been distributed from all of your Roth IRAs, the Tax Code says conversion funds are paid out next, first in – first out. The distribution of your conversion money is also tax-free because you already paid taxes on that money when you converted it to a Roth IRA. But if you’re under age 59 ½ at that time and it’s within five years of when you converted that money, you will be assessed the 10% early distribution penalty. If the money is used for qualified higher education expenses, such as tuition, books, and room-and-board, the penalty will not apply.
Finally, when all of your Roth IRA contribution and conversion money has been distributed, earnings (or interest) are paid out last. The distribution of Roth IRA earnings will be taxable to you unless it’s after 5 years from your first Roth IRA contribution, and you’re over age 59 ½, disabled, or buying a first home. So, if you use Roth IRA earnings to pay for higher education, it will be taxable to you if you’re under age 59 ½ and it’s within five years.
So you may be thinking that if you’re under age 59 ½, you should simply withdraw only your Roth contribution and conversion funds for higher education expenses so none of it will be taxable - although it still may be subject to the 10% penalty. Unfortunately, there is a huge cost associated with doing so.
The huge cost of using Roth IRA money for higher education expenses is the loss of tax-free build-up of income for your retirement years. The sooner you use some of that money, the bigger the loss will be in the future because less money is in the Roth IRA to compound tax-free. Tax-free income inside a Roth IRA grows the fastest because it will never be eroded by taxes. You must take that into account before deciding to deplete your Roth IRA nest egg.
Content Citation Guidelines
Below is the required verbiage that must be added to any re-branded piece from Ed Slott and Company, LLC or IRA Help, LLC. The verbiage must be used any time you take text from a piece and put it onto your own letterhead, within your newsletter, on your website, etc. Verbiage varies based on where you’re taking the content from.
Please be advised that prior to distributing re-branded content, you must send a proof to firstname.lastname@example.org for approval.
For white papers/other outflow pieces:
Copyright © [year of publication], [Ed Slott and Company, LLC or IRA Help, LLC - depending on what it says on the original piece] Reprinted with permission [Ed Slott and Company, LLC or IRA Help, LLC - depending on what it says on the original piece] takes no responsibility for the current accuracy of this information.
Copyright © [year of publication], Ed Slott and Company, LLC Reprinted with permission Ed Slott and Company, LLC takes no responsibility for the current accuracy of this information.
For Slott Report articles:
Copyright © [year of article], Ed Slott and Company, LLC Reprinted from The Slott Report, [insert date of article], with permission. [Insert article URL] Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article.
Please contact Matt Smith at email@example.com or (516) 536-8282 with any questions.