Rules on using IRA money for child's education?

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baw703916
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Rules on using IRA money for child's education?

Post by baw703916 » Tue Apr 14, 2015 10:51 am

I'm asking this question on behalf of a friend of a friend. I realize that using money from an IRA to fund children's college tuition isn't a very Boglehead thing to do. So no need to lecture me--I don't have any kids in any event.

But what are the rules on using IRA money (Roth or traditional) for college tuition? I understand that the principle in a Roth can be withdrawn for pretty much any purpose if it has been there at least five years. The IRS document (link) seems to say there won't be a penalty for any IRA withdrawal used for "qualified educational expenses", but I want to confirm that I am understanding things correctly.
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Re: Rules on using IRA money for child's education?

Post by livesoft » Tue Apr 14, 2015 10:59 am

Roth contributions (not conversions) do not have a 5-year rule when it comes to taxes, so taxes would be only on the gains.
Roth conversions (not contributions) apparently do have the 5-year rule, but then the Roth would have a basis and the taxes would be only on the gains since the conversion. That is, why would there be double taxes paid on any amounts already taxed? I don't think that can happen.

It seems like some of the education credits could more than cover the taxes on any IRA withdrawal.
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Re: Rules on using IRA money for child's education?

Post by Alan S. » Tue Apr 14, 2015 11:28 am

See p 25 of Pub 590 B for a complete description of the higher education penalty exception.

There are issues of which expenses are eligible, how scholarships and grants reduce eligible expenses, when room and board are qualified expenses, which institutions qualify etc.

Payments on a student loan are NOT qualified expenses, but payments of qualified expenses with loan money IS.

Timing is important. The exception applies to expenses paid in the calendar year, and the distribution must also be taken in the same calendar year, so the distribution can the payment can be several months apart, but must be in the SAME calendar year.

The penalty exception is claimed on Form 5329 using exception code 08. The 1099R will not show the penalty exception.

For a Roth distribution, the exception can waive the 10% penalty on conversions distributed within 5 years or on earnings that were distributed. No reason you could not use a mix of TIRA and Roth IRAs for the distributions, to control the taxable income.

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Re: Rules on using IRA money for child's education?

Post by markcoop » Tue Apr 14, 2015 11:36 am

Alan S. wrote:Payments on a student loan are NOT qualified expenses, but payments of qualified expenses with loan money IS.
Can you explain what you mean in the second half of this sentence?
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Re: Rules on using IRA money for child's education?

Post by Federal Agent » Tue Apr 14, 2015 6:28 pm

Can someone work me thru this scenario:
Parents have a kid in college.
Parents in the 25% fed tax bracket (assume no state taxes)
Kid will earn $5,000
Fed/State Grants: $0 (didn't qualify)

Annual Tuition: $10,000
Annual Room/Board: $8,000
Annual Tuition, Room & Board = $18,000 (total costs per year)
Scholarship: $1,000/yr
Annual borrowing: $12,000 (Perkins/Stafford, etc.)
Shortfall: ($5,000) each year

Mom has a 6 yr old ROTH account: $10,000 (balance)
- Contributions: $5,000
- Growth/Earnings: $5,000

Q1) Can she withdraw $5,000 from her ROTH in the first year to help cover the $5,000 shortfall without tax or penalty?

Q2) Then, are there any tax implications/penalties for withdrawing the remaining $5,000 the next year to cover the shortfall?


Now, with all the same assumptions above, what if it were a $10,000 Traditional IRA with zero cost basis?

Q1) Can she withdraw $5,000 from her Traditional IRA in the first year, then $5,000 the next year to help cover the yearly $5,000 shortfall without penalty? I assume the tax bill is $1,250 ($5,000 x .25) per year

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Re: Rules on using IRA money for child's education?

Post by Duckie » Tue Apr 14, 2015 6:45 pm

Federal Agent wrote:Mom has a 6 yr old ROTH account: $10,000 (balance)
[Ttl contributions: $5,000 (thus, $5k of the balance is from growth & earnings)]

Q1) Can she withdraw $5,000 from her ROTH in the first year to help cover the $5,000 shortfal without tax or penalty?
Yes.
Q2) Then, are there any tax implications/penalties for withdrawing the remaining $5,000 the next year to cover the shortfall?
She will owe taxes on the $5K earnings withdrawal. If she is under age 59.5 she will also owe a 10% penalty. See IRS Publication 590.

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Re: Rules on using IRA money for child's education?

Post by Alan S. » Tue Apr 14, 2015 7:17 pm

markcoop wrote:
Alan S. wrote:Payments on a student loan are NOT qualified expenses, but payments of qualified expenses with loan money IS.
Can you explain what you mean in the second half of this sentence?
Example: You have a tuition bill of 30k and take out a student loan. The loan proceeds pay the tuition and you therefore have 30k of qualified expenses that were paid from the loan funds.

Now you have to begin loan payments to pay back the expenses you already applied as qualified expenses. The principal part of the loan payment is not considered a qualified expense because you have already used those expenses. However, the interest on the loan can be claimed as an above the line deduction (student loan interest deduction) subject to certain limits. Therefore, all the elements receive tax breaks, but only once per dollar spent.

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Re: Rules on using IRA money for child's education?

Post by Federal Agent » Thu Apr 16, 2015 5:41 pm

Duckie wrote:
Federal Agent wrote:Mom has a 6 yr old ROTH account: $10,000 (balance)
[Ttl contributions: $5,000 (thus, $5k of the balance is from growth & earnings)]

Q1) Can she withdraw $5,000 from her ROTH in the first year to help cover the $5,000 shortfal without tax or penalty?
Yes.
Q2) Then, are there any tax implications/penalties for withdrawing the remaining $5,000 the next year to cover the shortfall?
She will owe taxes on the $5K earnings withdrawal. If she is under age 59.5 she will also owe a 10% penalty. See IRS Publication 590.
I've done some reading, and it appears to me that in the ROTH scenario, she would avoid the 10% tax penalty. Does anyone agree? Addionally, is Duckie correct that she would owe taxes on any withdrawals attributed to the ROTH account's growth/earnings?

Secondly, can anyone chime in on my Traditional IRA question at the bottom of my prior post?

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Re: Rules on using IRA money for child's education?

Post by Alan S. » Thu Apr 16, 2015 6:03 pm

You are correct. The 10% penalty on non qualified distributions of Roth IRA earnings can be waived by the higher education exception or any other exception the Roth owner may qualify for. File Form 5329 and enter exception code 08. However, taxes on the earnings would still be due.
Q1) Can she withdraw $5,000 from her Traditional IRA in the first year, then $5,000 the next year to help cover the yearly $5,000 shortfall without penalty? I assume the tax bill is $1,250 ($5,000 x .25) per year
Yes, as long as the expenses are qualified and the distribution is taken in the same calendar year that the expenses are paid, there is no dollar limit to the higher education exception.

In the scenario presented with 5k of qualified expenses for each year, the first year distribution might be taken from the Roth tax free, but the second year from the TIRA because the 2nd year taxes would be the same whether the earnings from the Roth or the TIRA was used for the distribution. In that case, preserve the Roth and use the TIRA. The Roth earnings will eventually be tax free if held until the Roth is qualified, but the TIRA will never be tax free unless you distribute it in a year with no taxable income.

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Re: Rules on using IRA money for child's education?

Post by Federal Agent » Fri Apr 17, 2015 6:54 pm

Alan S. wrote:You are correct. The 10% penalty on non qualified distributions of Roth IRA earnings can be waived by the higher education exception or any other exception the Roth owner may qualify for. File Form 5329 and enter exception code 08. However, taxes on the earnings would still be due.
Q1) Can she withdraw $5,000 from her Traditional IRA in the first year, then $5,000 the next year to help cover the yearly $5,000 shortfall without penalty? I assume the tax bill is $1,250 ($5,000 x .25) per year
Yes, as long as the expenses are qualified and the distribution is taken in the same calendar year that the expenses are paid, there is no dollar limit to the higher education exception.

In the scenario presented with 5k of qualified expenses for each year, the first year distribution might be taken from the Roth tax free, but the second year from the TIRA because the 2nd year taxes would be the same whether the earnings from the Roth or the TIRA was used for the distribution. In that case, preserve the Roth and use the TIRA. The Roth earnings will eventually be tax free if held until the Roth is qualified, but the TIRA will never be tax free unless you distribute it in a year with no taxable income.
Thank you Alan S. that is an excellent point: use the TIRA for Year 2 qualified college expenses, pay the tax (with no penalty since it meets an IRS exception), and don't use the earnings portion of the ROTH.That allays for tax free withdrawals of the ROTH's earnings, after age 59 1/2.

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Re: Rules on using IRA money for child's education?

Post by Federal Agent » Sat Apr 18, 2015 10:48 am

Hey All,

Below is a "cut and paste" of the below URL link from Schwab's website...Hey, I hope I'm interpreting this correctly: it Looks like you can withdraw the ROTH earnings free of tax and penalty if the account is 5yrs+ old and the withdrawals are used for qualified educational expenses (like college tuition).

http://www.schwab.com/public/schwab/inv ... awal_rules


ROTH IRA WITHDRAWAL RULES

With a Roth IRA, contributions are not tax-deductible, but earnings can grow tax-free. Roth IRA withdrawal and penalty rules vary depending on your age.

Age 59 and under.

You can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA.

Withdrawals from a Roth IRA you've had less than five years.
If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties. You may be able to avoid penalties (but not taxes) in the following situations:
  • You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
    You use the withdrawal to pay for qualified education expenses.
    You're at least age 59½.
    You become disabled or pass away.
    You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
    The distribution is made in substantially equal periodic payments.1
Withdrawals from a Roth IRA you've had more than five years.
If you’re under age 59½ and your Roth IRA has been open five years or more,1 your earnings will not be subject to taxes if you meet one of the following conditions:
  • You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
    You use the withdrawal to pay for qualified education expenses.
    You're at least age 59½.
    You become disabled or pass away.
    You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
    The distribution is made in substantially equal periodic payments.1
Age 59½ to 70

Withdrawals from a Roth IRA you've had less than five years.
If you haven’t met the five-year holding requirement, your earnings will be subject to taxes but not penalties.

Withdrawals from a Roth IRA you've had more than five years.
If you’ve met the five-year holding requirement, you can withdraw money from a Roth IRA with no taxes or penalties.


Age 70½ and over

Withdrawals from a Roth IRA you've had less than five years.
If you haven’t met the five-year holding requirement, your earnings will be subject to taxes but not penalties.

Withdrawals from a Roth IRA you've had more than five years.
If you’ve met the five-year holding requirement, you can withdraw money from a Roth IRA with no taxes or penalties.

Footnote: 1. The IRS treats a Roth IRA withdrawal made more than five years after the first tax year in which you made a contribution (including earnings) as a “qualified distribution.” This means it is not taxable or subject to a penalty as long as you satisfy one of these qualifying conditions: You’re at least 59½, you become disabled or pass away, or you use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase

So, did I read it correctly that the whole ROTH balance can be used toward tuition without penalty nor taxes, if ROTH is 5+ yrs old, for being under age 591/2?

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Re: Rules on using IRA money for child's education?

Post by alex_686 » Sat Apr 18, 2015 10:55 am

baw703916 wrote:I'm asking this question on behalf of a friend of a friend. I realize that using money from an IRA to fund children's college tuition isn't a very Boglehead thing to do. So no need to lecture me--I don't have any kids in any event.
I would argue that it is a very Boglehead thing to do. You should squeeze every tax advantage you have. A IRA is a tax advantage account. Don't let word the "retirement" mislead you. If you have a choice between putting your child's college savings in a IRA or some type of education account, the IRA wins out almost every time. Only if you are bumping up against the limits of retirement contributions should you think about educational accounts.

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Re: Rules on using IRA money for child's education?

Post by Federal Agent » Sat Apr 18, 2015 1:05 pm

Alex makes an excellent point... neverthought of it that way

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Re: Rules on using IRA money for child's education?

Post by baw703916 » Sat Apr 18, 2015 1:20 pm

Thanks, alex_686. I may have been unnecessarily defensive in the OP. :)

Is part of the reason that a Roth is actually better for funding college (assuming using it in that way doesn't overly deplete retirement accounts) is the way it (doesn't) show up on the FAFSA form?
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Re: Rules on using IRA money for child's education?

Post by alex_686 » Mon Apr 20, 2015 8:55 am

baw703916 wrote:Is part of the reason that a Roth is actually better for funding college (assuming using it in that way doesn't overly deplete retirement accounts) is the way it (doesn't) show up on the FAFSA form?
I think most retirement accounts are exempted. IRAs, 401Ks, Roths, Annuities, etc.

You were not being defensive. I was being annoyed with the unnecessarily complexity of the US tax code / tax advantage accounts. It seems only the wealthy can afford to buy the advice to maneuver around and figure it out.

Which takes me to my next point. I am always a little doubtful about free internet advice. I will suggest something non Bogglehead like and suggest that you look for a FR. I personally think FRs are good – or at least that a good FR is well worth the cost. .Maneuvering around complex issue often benefits with someone with an outside perspective and good knowledge. Now, back to saying something Bogglehead like – most FRs' skills range from the inept to the modestly competent. Most of the industry has adopted a indirect and high fee structure. Finding a good FR is hard. It has been 4 years since I lost my last FR due to retirement and I have not been able to find a new one yet. (I am not looking very hard, but my financial situation is straightforward.)

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Re: Rules on using IRA money for child's education?

Post by JW-Retired » Mon Apr 20, 2015 9:07 am

Maybe I'm dense but what is a FR? So many repeats it can't be a typo.
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Re: Rules on using IRA money for child's education?

Post by alex_686 » Mon Apr 20, 2015 12:14 pm

JW Nearly Retired wrote:Maybe I'm dense but what is a FR? So many repeats it can't be a typo.
My mistake – should always reference acronyms. FR = Financial Represented. a.k.a. broker, financial advisor (FA), etc. You know, those people who charge fees to give you advice and sell you products. I think the fee only model is the better model. Less incentive to see you bad funds with high 12b-a fees. However, there are fewer of these out there. Your mileage may vary.

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Re: Rules on using IRA money for child's education?

Post by grp2c » Fri Feb 23, 2018 2:22 pm

So since traditional ira and roth ira withdraws to pay for qualified higher education expenses are not subject to the 10% penalty, if you live in a state that does not allow a tax deduction for 529 contributions, given the restrictions on withdraws from a 529 should you choose to plan to use future traditional ira and roth ira withdraws for education expenses instead of opening a 529 account.

Or maybe still consider a 529 account if you are consistently maxing out retirement accounts and still need tax deferred space.

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Re: Rules on using IRA money for child's education?

Post by miamivice » Fri Feb 23, 2018 2:30 pm

alex_686 wrote:
Sat Apr 18, 2015 10:55 am
baw703916 wrote:I'm asking this question on behalf of a friend of a friend. I realize that using money from an IRA to fund children's college tuition isn't a very Boglehead thing to do. So no need to lecture me--I don't have any kids in any event.
I would argue that it is a very Boglehead thing to do. You should squeeze every tax advantage you have. A IRA is a tax advantage account. Don't let word the "retirement" mislead you. If you have a choice between putting your child's college savings in a IRA or some type of education account, the IRA wins out almost every time. Only if you are bumping up against the limits of retirement contributions should you think about educational accounts.
Uh, no.

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Re: Rules on using IRA money for child's education?

Post by starter2013 » Sun Apr 08, 2018 9:36 am

grp2c wrote:
Fri Feb 23, 2018 2:22 pm
So since traditional ira and roth ira withdraws to pay for qualified higher education expenses are not subject to the 10% penalty, if you live in a state that does not allow a tax deduction for 529 contributions, given the restrictions on withdraws from a 529 should you choose to plan to use future traditional ira and roth ira withdraws for education expenses instead of opening a 529 account.

Or maybe still consider a 529 account if you are consistently maxing out retirement accounts and still need tax deferred space.
I have this exact question. Did you find your answer?

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Re: Rules on using IRA money for child's education?

Post by Nate79 » Sun Apr 08, 2018 10:32 am

grp2c wrote:
Fri Feb 23, 2018 2:22 pm
So since traditional ira and roth ira withdraws to pay for qualified higher education expenses are not subject to the 10% penalty, if you live in a state that does not allow a tax deduction for 529 contributions, given the restrictions on withdraws from a 529 should you choose to plan to use future traditional ira and roth ira withdraws for education expenses instead of opening a 529 account.

Or maybe still consider a 529 account if you are consistently maxing out retirement accounts and still need tax deferred space.
First, how are you saving for retirement? If you use up all your IRA's to pay for kids college you still need money for retirement. Now if you are choosing between IRA and 529 I would fund retirement first. But for college IRA's are not very effective as even though you won't pay the 10% penalty you will still pay taxes on the earnings (for Roth) and entire withdrawal (traditional) at your marginal tax rate. You can withdrawal your Roth contributions tax and penalty free so there is that option. On the other hand a taxable account you will pay tax on the gains at the capital gains tax rate which is lower than marginal tax rate.

So in my case I max out Roth/traditional IRA and moderately fund 529 and taxable accounts to have a mix of accounts available for retirement and kids college.

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Re: Rules on using IRA money for child's education?

Post by renner » Sun Apr 08, 2018 10:54 am

alex_686 wrote:
Mon Apr 20, 2015 8:55 am
I was being annoyed with the unnecessarily complexity of the US tax code / tax advantage accounts. It seems only the wealthy can afford to buy the advice to maneuver around and figure it out.
Have to agree with this. I consider myself educated (PhDed) and fairly resourceful, but find the tax and financial system extremely difficult to navigate. I image no less frustration for those with less resource.

Political ideology aside, I would like to see clearer and simpler tax rules.

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Re: Rules on using IRA money for child's education?

Post by grp2c » Mon Apr 09, 2018 2:55 pm

Nate79 wrote:
Sun Apr 08, 2018 10:32 am
But for college IRA's are not very effective as even though you won't pay the 10% penalty you will still pay taxes on the earnings (for Roth) and entire withdrawal (traditional) at your marginal tax rate. You can withdrawal your Roth contributions tax and penalty free so there is that option.
Ahh. Thanks Nate, I thought there was no income tax and no penalty for withdraws of roth earnings for educational expenses. But considering you do have to pay income tax on those withdraws if it is not qualified, it would not be a good plan to use a roth ira for educational expenses. So confusing.

With my 401k, I can do aftertax contributions and roll them into a roth ira (mega backdoor roth). I'll plan to do backdoor roth + mega backdoor roths annually. Then I can withdraw the basis of my roth ira tax free and penalty free for children's educational expenses. I may fund a small 529 account as well.

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