The pot of money in an individual retirement account (IRA) is supposed to be off-limits for meeting daily spending needs. But the rules do allow savers to take out funds under certain circumstances without incurring the typical early withdrawal penalties that kick in if a saver taps an IRA before age 59 1/2. Paying for tuition and other college expenses is one of them.
With tuition costs on the rise—average tuition costs and fees for four-year public universities were 13% higher in the academic year 2019-2020 compared to 2010-2011, and 18% higher for private institutions—more Americans may consider tapping retirement funds to cover college expenses.
What to know about using IRA funds for qualifying education expenses
Qualified higher education expenses is one exception to the IRS’s 10% early withdrawal penalty for IRAs. That means it’s possible to do an IRA withdrawal to pay for tuition, fees, and room and board for the account holder, their spouse, or their children or grandchildren’s higher education. An IRA withdrawal for education must abide by several rules:
- The distribution may be counted as income. Which may impact what financial aid one qualifies for in the future. IRA assets aren’t considered as part of the FAFSA review, but once IRA funds are withdrawn, it could have an impact on any need-based financial aid in the future.
- Income tax may apply. Withdrawals from traditional IRAs are usually subject to income tax. Withdrawals from Roth IRAs are not subject to income tax as long as the account holder has had the account for five years and only takes out the original contributions—and not earnings. (This is because Roths are funded with after-tax dollars.)
- The distribution should happen in the same year that the expenses are due. The distribution of the IRA funds needs to happen in the same year that qualified education expenses are paid. Tuition is paid either by semester or annually, meaning withdrawals may need to be done annually.
- The amount withdrawn must not exceed the total for qualified education costs. If it does, the 10% penalty will apply on the excess.
- Account holder’s can’t replenish the funds. Unlike 401(k) loans, in which the account holder pays back the borrowed money with interest to their account, IRA withdrawals can’t be paid back. Once they’re taken out, it’s not possible to pay back the funds.
How IRA withdrawal for education can impact financial aid
As part of filling out the FAFSA to receive financial aid, tax returns from two years prior are used in evaluating income. When FAFSA reviews total asset information, IRA funds are excluded and don’t impact financial aid.
However, that shifts once there is an amount withdrawn from IRA funds for college. That distribution is subject to taxes and will be considered income and may reduce eligibility for need-based financial aid in the future. FAFSA must be filled out every academic year.
Traditional IRA vs Roth IRA funds for education expenses
Withdrawals from Roth IRAs receive different tax treatment than traditional IRAs in this case. That’s because of how Roth IRA distributions are normally taxed. Roth IRAs use after-tax dollars, so if the account holder only withdraws money they contributed originally (rather than any gains earned on that money), income tax doesn’t apply—because it’s already been paid.
Traditional IRAs use pretax dollars, so though one may avoid the penalty, income taxes will still need to be paid as part of the distribution as part of that tax year.
Mistakes that may trigger a 10% penalty
IRA withdrawals for higher education must be executed properly to avoid unintentionally triggering an early withdrawal penalty. Some common mistakes that may lead to a penalty include:
- Taking an IRA withdrawal for education expenses in the wrong year. The distribution must take place within the same tax year that expenses are paid. Taking out a withdrawal any other time may trigger a penalty.
- Taking a withdrawal for unqualified expenses. Qualified expenses include tuition for a student who is enrolled half-time or more, fees, room and board, and other acceptable expenses that are “required” for enrollment such as supplies or specific equipment a student might need for a particular course. The school must be considered a postsecondary school, and it must take part in student aid programs governed by the Department of Education.
- The distribution is more than the total of education costs. IRA withdrawals that are used for education purposes must be reported via Form 5329, which illustrates the amount distributed. Any excess that may be subject to the 10% early withdrawal tax.
Pros and cons of using IRA withdrawal for education expenses
Using money from retirement is essentially borrowing from the future to pay for expenses now. That can come with potential benefits—like reducing burdensome debt for oneself or one’s children—but also potential downsides—like lost gains.
Pros:
- Withdrawal IRA funds penalty-free. That means there is no penalty for early withdrawals when used for covered education expenses.
- Can reduce student loan debt. Having an additional funding source may mean reducing or avoiding student loan debt. Student loan interest accrues daily, which can add up fast. Avoiding or limiting debt can also mean no monthly payment in the future.
- Borrowing from Roth IRA contributions may be tax-free. Using just Roth IRA contributions—and not Roth earnings—usually doesn’t incur taxes because those contributions were made with after-tax dollars in the first place.
Cons:
- Miss out on potential gains and lower retirement funds. In theory, retirement savings should be for just that—retirement. Taking an early distribution for education costs means missing out on compound interest and precious time in the market to build portfolio value.
- Lost returns may be more than savings on student loan interest. The average stock market return has, on average, been about 7%—which could be higher than the interest rate one would pay on student loans.
- May impact financial aid. Taking out money from traditional IRAs or Roth IRAs for college can count as income (even if the distribution itself is tax-free) and affect FAFSA. Because of the increase in income, it may reduce need-based financial aid. FAFSA uses tax returns from two years prior.
- Restrictions on time and amount. To avoid the early withdrawal penalty, the funds in the IRA must be distributed in the same year that they’re used to cover costs. The funds are also limited to qualifying education expenses that are “required,” such as tuition, fees, books, and supplies. While there isn’t a cap on the withdrawal, for tax purposes, limit the amount to qualified education expenses.
The bottom line
Borrowing from requires some careful consideration. Though tapping an IRA for college can be penalty-free, there are potential income taxes to consider, a potential impact on FAFSA, and of course, the blow to overall retirement savings. Though student loans may not be optimal, they may have a lower interest rate than the return on investment with your IRA funds. If there are questions, it’s always best to talk to a finance or tax professional.