Using a Roth IRA to Pay for Higher Education? Be Careful!
By Sarah Brenner, JD
Follow Us on Twitter: @theslottreport
With college costs almost certain to keep increasing each year, parents need to explore every possible tool available to meet the challenge of paying for higher education. Roth IRAs are not just for retirement savings. They can play a vital role in education savings. However, the rules can be tricky. Before you take a distribution from your Roth IRA to pay that tuition bill, be sure you understand the tax consequences.
Contributions and Conversions
If you are thinking of tapping your Roth IRA to pay for college, there is good news if you just withdraw contributions or converted funds. A Roth IRA distribution of tax-year contributions will be tax and penalty-free if used for higher education. Why? Well, your contributions are always available to you tax and penalty free. That part is easy.
Converted funds are a little more complicated. The general rule is that if you are under age 59 ½ you must satisfy a five-year holding period before you can withdraw converted funds without the 10% early distribution penalty applying. However, there is an exception to the penalty when the funds are used for higher education. This means that if you are planning to use converted funds from your Roth IRA to pay for qualified education expenses, those funds will always be available to you tax and penalty free. It does not matter how old you are or how long ago you converted. More good news is that contribution and converted funds are considered the first money to leave your Roth IRA under the Roth IRA ordering rules.
Earnings are considered the last funds to leave your Roth IRA under the ordering rules, so a Roth IRA distribution that includes earnings is a little complicated.
To have a qualified Roth IRA distribution of earnings, a five-year holding period must be satisfied, and the distribution must be taken when you are over age 59 ½, disabled, purchasing a first home or deceased. Higher education is not a reason for a qualified Roth IRA distribution. Therefore, if you take a Roth IRA distribution to pay for higher education and you are not 59 ½ or disabled, the portion of your distribution that represents earnings will be taxable. However, no penalty will apply because there is an exception for higher education expenses.
Consider the following example:
Juanita, age 55, has a Roth IRA valued at $20,000. Her Roth IRA consists of $18,000 of converted funds and $2,000 of earnings. She takes a total distribution to pay for her son’s college tuition believing it will be tax and penalty free. She is right that the distribution of converted funds will be tax and penalty free. However, while the earnings portion ($2,000) of the distribution will not subject to penalty, those earnings will be taxable.
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.