Chapter 14
Saving in Your Retirement Plans: The IRA Dilemma
In This Chapter
Using retirement savings to pay for educational expenses
Sidestepping paying penalties if you take distributions to pay for college
Figuring out when dipping into your retirement funds does and doesn’t make sense
As you begin the run-up to college, you may be patting yourself on the back, sure in the knowledge that you’ve saved every penny you’re likely to need to pay for your child’s college education. If so, fantastic! You’ve overcome a huge obstacle, and now all your child needs to do is be accepted to the college of his or her choice.
If, on the other hand, you’ve left saving for college until late in the day, and are now sweating because you don’t have enough funds in your Section 529 plan, Coverdell Education Savings Account, or Series EE or Series I savings bonds, all is not lost. If you’re like many people, especially those who had children later but who started saving for retirement early on in their careers, you may actually have adequate money saved to not only fund your retirement but also to make up the difference between college costs and college savings.
In this chapter, you find out how to access some of the money in your retirement accounts (if you absolutely, positively must) to pay for qualified educational expenses. You see how best to liberate that money so that you minimize the amount of tax you’ll pay on it. You explore how to strategically move savings around in order to actually take distributions from the most tax-advantageous account. And finally, you take a look at how using these funds will affect your own retirement down the road, and why you may want to view using any part of your retirement savings to fill college savings gaps as a last resort.
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Using Your Traditional IRA to Cover College Expenses
If you’ve been contributing and saving every year in your traditional Individual Retirement Account (IRA), you may already have a tidy sum socked away and earmarked for your retirement. That money may beckon to you when the bills for your child’s tuition and other educational expenses begin to roll in and your savings in other areas just aren’t enough to cover them all. Clearly, the temptation is great — that money is just sitting there, you don’t need any of it yet for retirement purposes, and your only option may be to either take a distribution from your IRA or take a loan to pay for those pesky college expenses.
What’s more, you can do it and not pay an early distribution penalty (if you plan things right). The IRS allows you to take penalty-free distributions from your traditional IRA before you turn 59 1/2 years old if that distribution is used to pay qualified educational expenses, although you do, of course, have to pay the income tax on the distribution.
How much money will you need in order to retire and maintain your current lifestyle? Calculators that allow you to make this estimate are available on the Internet and in most money management software packages. In addition, any good financial planner should be able to help you make this calculation.
How much money do you currently have saved in your (and your spouse’s) various retirement funds, investment accounts, and so on?
If you use part, or all, of your current retirement savings to pay for college expenses for your kids, will you still be able to save enough to adequately pay for your retirement after doing so?
Figuring out qualified expenses
You may pay only for qualified higher educational expenses. Once again, these expenses include tuition, fees, books, supplies, and equipment required for enrollment at a qualified educational institution (schools qualified to participate in federal financial aid programs administered by the U.S. Department of Education). In addition, if the student attends school at least half-time, room and board paid to the school itself or as determined by the school also qualifies.
You may only pay qualified expenses for yourself, your spouse, your children (and your spouse’s children, if they are different), and your and your spouse’s grandchildren.
If your beneficiary is a special-needs student, services incurred by him or for his benefit qualify. Of course, regulations defining who is a special-needs student and what services are covered by this designation haven’t been issued yet — use your best judgment when making a determination of what you think will be covered.
Calculating the amount of the distribution not subject to the 10 percent penalty
If you’re under age 59 1/2 when you take a distribution from your traditional IRA, remember that the general rule is that you will pay income tax on one of the following:
The full amount of the distribution if you were able to make pre-tax contributions to the account
The income earned in the account over its lifetime if you made after-tax contributions
An amount somewhere in the middle if some of your contributions were made pre-tax and others were made after-tax
In addition to the income tax piece, you’re also liable for a 10 percent penalty because you’ve taken an early distribution. However, when you use all, or a part, of that distribution to pay for qualified educational expenses, you’re creating an exception to this rule. And if you use a distribution from your traditional IRA to pay for only qualified expenses, the result is clear. You’ll need to calculate the portion of your distribution that’s taxable to you and then pay the income tax on it, but you’ll escape the penalty entirely.
Tax-free Coverdell and/or Section 529 withdrawals
Tax-free scholarships
Tax-free, employer-provided educational assistance
Any other tax-free payment (other than a gift or bequest) that your student receives due to enrollment at a particular institution, such as veteran’s benefits, AmeriCorps benefits, and the like
If your student receives payments or credits from these sources equal to or in excess of the total amount of their qualifying expenses, all of your traditional IRA distribution will be subject to the 10 percent penalty. If the IRA distribution partially exceeds the adjusted qualifying expenses, only that part that is in excess will be assessed the penalty.
For example, Julia’s annual qualifying educational expenses at her university are currently $30,000 per year, and she expects that the total cost, including all nonqualifying expenses such as insurance and transportation, will be $35,000. This year, she’s been extremely fortunate, and the university has given her a $5,000 scholarship. In addition, her mother’s employer gives her a $1,000 scholarship. However, Julia’s parents were late in starting a 529 plan for her benefit, so there is only $15,000 left in that account, and her parents distribute the full amount to cover part of her current expenses. Now, she has $21,000 towards the total $30,000 qualifying amount. To make up the funding gap, Julia’s father has an old IRA account which doesn’t play a huge role in his retirement planning, so he decides to cash it in to come up with the remaining $14,000 that Julia will need to pay her expenses, both qualifying and non, for the current year.
On the basis of these numbers, Julia’s family will face the following tax consequences:
Julia will pay no tax on the $15,000 Section 529 distribution, as the full amount of the distribution is used to pay for qualifying educational expenses, nor will she pay any tax on the $5,000 university scholarship or the $1,000 scholarship from her mother’s employer.
Julia’s parents will pay income tax only on $9,000 of the total $14,000 IRA distribution, since that is the amount left on the table after all other tax-free sources of income were considered.
Julia’s parents will pay both income tax and a 10 percent penalty on the remaining $5,000 of the IRA distribution, since even though that money was used to pay Julia’s expenses, those expenses were not qualified educational expenses.
Tapping into Your Roth IRA for College Savings
Among the more recent entries into the retirement savings field, the Roth IRA has been a valuable addition, especially for many middle-income people who couldn’t make tax-free contributions into a traditional IRA. If you meet the income limitations and are permitted to make contributions, Roth IRA’s allow you to save money by making after-tax contributions into a retirement account. Over time, your money grows as it earns interest, dividends, and capital gains. When you finally begin to take distributions, your withdrawals come back to you completely tax-free. There is no tax-deferral element here, either at the front end, when you make your contributions, or at the back end, when you take withdrawals. Instead, you pay the income tax upfront and take withdrawals tax-free.
Making distributions and avoiding penalties with a Roth IRA
Roth IRA’s differ from traditional IRA’s in many aspects, but especially regarding the distribution rules. There are certain requirements about who may take distributions and when they may take them. Failure to fulfill both of these requirements may result in a 10 percent penalty on the income portion of the distribution:
Your Roth IRA account must be open for a period of five years before you may take any distributions tax-free. If you fail the five-year holding period test, the income portion will be taxed at your ordinary income tax rates, and you will, most likely, be charged a 10 percent penalty (although certain exceptions apply).
Your distribution must satisfy one of the following conditions:
• It must be made on or after the date on which you attain the age of 59 1/2.
• It must be made to your estate or your named beneficiary on or after your death.
• It must be attributable to your being disabled.
• Up to $10,000 may be used to pay for qualified first-time homebuyer expenses.
Clearly, if you’re an older parent or grandparent (over age 59 1/2) and you’ve had a Roth IRA sitting in the wings for at least five years, you’re free to use it to pay whatever educational expenses you want. Because the distribution will be made to you and it’s already designated as a tax-free distribution, you may choose to use that money for whatever purpose your heart desires.
If, on the other hand, you have a Roth IRA and you haven’t yet reached that magic age, you’re still allowed to take distributions from your Roth IRA to pay for qualified educational expenses. You should note, though, that the income portion of these distributions will be taxable to you, although no 10 percent penalty will be applied on money used to pay qualifying expenses. And here, the expenses that qualify are exactly the same as those for a traditional IRA. In essence, if you use your Roth IRA to pay for college and you’re younger than 59 1/2, the net result to you is almost identical as it would be if you used your traditional IRA — you pay the income tax, but you avoid the penalty.
Playing with Roth IRA’s flexibility without getting burned
If you’re eligible to make contributions to a Roth IRA, it’s a terrific way to save for the future. And, if you’re an older parent, it gives you a great deal of flexibility when you’re trying to determine how much to save for college and how much for retirement. With a Roth, you can gain many of the same tax benefits of a Section 529 plan or Coverdell Education Savings Account without limiting the use of your savings to only future educational expenses.
Making Early Distributions from Other Retirement Accounts
If you’re like many people, you may not have a traditional IRA or a Roth IRA. Maybe you have some other form of retirement savings in some sort of retirement account. Not surprisingly, these accounts are intended to be there for you when you retire; however, many of them are available under limited circumstances to pay for other expenses, including qualified educational expenses.
The following list is by no means all-inclusive, but it does cover many of the major types of self-funded and employer-sponsored retirement plans and what the tax consequences are if you need to take a distribution to pay for college expenses:
401(k) plan: This plan allows you to make pre-tax contributions to a retirement fund for your benefit. Your employer sets up and administers the plan and may match all or part of your contribution. If you take an early distribution (a so-called hardship distribution) from this plan to pay for educational expenses, be prepared to pay a lot of tax on the distribution. You’ll pay income tax at your top tax bracket on the full amount (remember, you’ve never paid tax on any of it), plus a 10 percent penalty. If you absolutely must access money from this account, you’re much better off taking a loan from your plan, if your employer allows it, and then making sure to pay it back within five years.
403(b) plan: This is essentially the same as a 401(k) plan, but is offered to public sector and nonprofit organization employees. Once again, early distributions for educational expenses are fully taxable and subject to the penalty.
SEP IRA: A Simplified Employee Pension (SEP) is administered in much the same way as a traditional IRA. The biggest difference is that your employer — not you — will make the contributions to this account for your benefit. Because it runs exactly like an IRA in all other respects, it follows the rules for traditional IRAs regarding early distributions to pay for qualified educational expenses. You’ll pay the income tax, but there won’t be any penalty.
SIMPLE retirement account: A Savings Incentive Match Plan for Employees (SIMPLE) may be set up by your employer to follow either the 401(k) plan model or the traditional IRA model. It allows you to make contributions to your retirement fund that your employer matches. Your tax cost, should you take an early distribution to pay for qualified educational expenses, depends on what type of plan you belong to. Beware, though: If you put money in only to take it out within your first two years of participation in the plan, a 25 percent penalty may be tacked on to your tax bill for good measure.
Saving for college with retirement accounts: Good or bad idea?
So much of financial planning rests on the contents of your crystal ball, and any savings plan is only as focused as what you can see there. Which means that there is absolutely no clarity whatsoever when you’re trying to decide where to save money and how much you need to put away.
Using retirement accounts to save for your retirement makes perfect sense. These accounts are designed to defer income you’re earning now and pick it up later in your life. For most people, that means that you’ll also be paying income tax on it at a time when your income will be more limited than it is now, thereby reducing overall the amount of income tax you’ll pay on that money.
These accounts aren’t intended to pay for college expenses, which doesn’t mean that they can’t be used for that purpose. It does mean, though, that you may lose many of the advantages that you might have were you to keep the money in the account until you hit retirement age.
As you look at all the assets you have available to pay for college expenses (including your retirement accounts), keep the following in mind:
Tax deferrals: Should you take a distribution to pay for college expenses, you’ll be picking up that income on your current year’s tax returns. Many people are in their highest earning years when their children are in college, so you may find that you pay tax on these distributions at an even higher rate than you would have if you’d never put the money into the account.
Reduction in available retirement income: You have no idea how long you’ll live, or how much money you’ll need to see you through the end of your life. Using retirement funds to pay for college expenses may compromise your future standard of living.
Great flexibility in uncertain family situations: Face it: You don’t know for certain whether your children will attend college, or where, or exactly how much it will cost. If you don’t want to put too much into specific college savings accounts because of your uncertainties, adding a cushion to your retirement accounts may provide you with whatever extra you may need to meet all contingencies.
Rolling Over Retirement Accounts to Obtain Maximum Benefit
Clearly, when you’re looking to raid your retirement accounts to pay for educational expenses, not all types of accounts are created equal. And, if you’ve spent your entire working life with one company, you have only the one retirement plan that company offers and may be out of luck. You aren’t allowed to take money out of a retirement plan of the company you’re currently working at and switch it to another sort of retirement plan.
On the other hand, if you’re like most people, you probably have moved periodically from job to job over the course of your career as you looked for that perfect place to put down your working roots. And you may have accumulated one or more retirement accounts along the way. If so, you may be in luck.