Using an IRA to Pay for College Expenses | Lord Abbett
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Retirement Perspectives

In certain situations, you may be able to use a retirement account to pay for higher-education expenses without early-distribution penalty. Here's what you need to know

Read time: 3 minutes

Of all the financial challenges facing American families today, saving for retirement while paying for a child’s college education ranks high on the list. According to the College Board, the average cost for tuition, room and board for college ranges from $43,280 for a public college and up to a $54,800 for a private one.1 It’s not surprising, then, that Boomers and Generation Xers fear they may never be able to retire in order to pay those kinds of bills.

The IRA college-expenses exception

Congress acknowledged such a financial burden by making IRAs more accessible for certain educational expenses. Generally, if an account owner takes a distribution from his or her IRA before age 59½, the distribution is subject to income tax plus a 10% early-distribution penalty tax. However, an exception applies when proceeds are used to pay for higher education.

Qualified higher-education costs include post-secondary tuition, fees, room and board, books, supplies, and required equipment. Computers, internet access, and related equipment also count as long as the student uses them during the year that he or she is in school.

In addition to using your IRA (including SEP and SIMPLE IRA) for your own higher-education expenses, the distribution extends to your spouse, child, or grandchild (siblings, nieces, nephews, and cousins don’t qualify for the exception).

Remember though, that while you won’t have to pay the IRS a 10% early-distribution penalty tax, the distribution is generally still includable in taxable income (federal and state, if applicable).

PRACTICE TIP: An individual must be considered at least a half-time student for room and board to qualify. And qualified higher-education expenses covered with tax-free, educational-assistance payments (i.e., scholarships, Pell grants, Coverdell education-account distributions, etc.) are not eligible for the IRA exception.

What kind of college is allowable?

Only post-secondary, higher education is considered; K-12 expenses are not allowable under the law. The IRS defines an eligible educational institution as “any college, university, vocational school, or other post-secondary, educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned, profit-making) post-secondary institutions. It even includes certain foreign institutions of higher learning.  

 

Key Takeaways:

  • While it’s always a good idea to earmark retirement accounts for retirement only, paying for college can be accomplished using IRA funds under certain circumstances.
  • Consider a Roth IRA for its unique provision of allowing distributions when younger than 59-1/2 and holding funds for less than five years.
  • Recordkeeping is critical to ensure that qualified-education expenses satisfy the exception. Check with a tax professional.

 

No dollar limit

While there is no dollar limit on how much of your IRA you can use for educational costs, the distribution can’t exceed the amount of education expenses paid in the same calendar year. Importantly, the education expense and the IRA distribution must occur in the same calendar year. For example, if you are paying tuition in January 2021, you can take a distribution from your IRA anytime between January 1, 2021 and December 31, 2021 and have it qualify for the educational-expense exception.

Considering a Roth IRA

One of the best and widely known benefits of a Roth IRA is the tax-free distributions, which occur if you are age 59 ½ and have held the account for five years (or longer); then all funds (including earnings) will be distributed tax and penalty free.

A lesser known but just as valuable, Roth IRA benefit allows an account holder to distribute contributions tax and penalty free at any time or age without regard to the five-year holding period. Therefore, even if you’re not 59 ½ or haven’t met the five-year holding period, you may still be able to withdraw contributions from your Roth IRA tax and penalty free to cover costs associated with college. Roth IRA contributions can be distributed at any age and at any time, for any reason, (distributions aren’t limited to expenses associated with higher education) fully tax and penalty free.

EXAMPLE: Let’s say Tom contributed $40,000 over 10 years to his Roth IRA.  Today the account is valued at $50,000. Tom can distribute up to $40,000 (the amount he contributed) tax and penalty free to help him defray higher-education costs.

 

PRACTICE TIP: This exception does not apply to 401(k) and similar plans. Instead, a 401(k) plan may (but is not required to) allow for financial hardship distributions, which are considered “immediate and heavy financial need” and subject to a 10% early- distribution penalty in addition to income taxes.  They qualify for higher education if the distribution is related to “Tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee or the employee’s spouse, children, dependents or beneficiary.”

 

PRACTICE TIP: Amounts converted to a Roth IRA can, in certain situation, also be distributed tax and penalty free. Even if you’re under age 59 ½, Roth IRA conversion funds can be withdrawn tax and penalty free as long as the conversion took place five years ago or longer. A pre-59 ½ distribution occurring prior to satisfying the five-year holding period will not be subject to income tax but will be assessed a 10% early-distribution penalty tax.

Good recordkeeping is a must

It’s critical to retain records (i.e., receipts) for the higher-education expenses paid for with an IRA. The onus is on the account owner to substantiate that the distribution has satisfied the exception for qualified-education expenses. The rules are complicated. Check with your tax professional prior to tapping your IRA.

 

1 The College Board’s Trends in College Pricing 2020-21, Full-Time Undergraduate Budgets

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

FOR MORE INFORMATION: Lord Abbett Client Service: 888-522-2388 | Visit us at: lordabbett.com Lord Abbett mutual fund shares are distributed by LORD ABBETT DISTRIBUTOR LLC 90 Hudson Street, Jersey City, NJ 07302-3973
 

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