We’re still discussing ways families can save money for top financial goals (like retirement), qualify for need-based financial aid, and yet use their savings to pay for their kids’ college costs if the need (and opportunity) arises. We’ve already talked about the most important tools, like pre-tax retirement accounts (401ks and 403bs), and Roth IRAs. This week will talk about the ways parents can use money in traditional IRAs to cover higher education expenses.
Individual retirement accounts (IRAs) can generally be opened and funded by anyone who has earned income, or is married to someone who has earned income. The accounts can be established at most full-service and discount investment firms (like Fidelity, Schwab, and Vanguard), as well as at some insurance providers, banks, and credit unions. For 2016 the limits to contributions are the lesser of the earnings, or $5,500 ($6,500 for those 50 and over). Contributions can be made after January 1st of the year in question, but must be made by the tax-filing deadline of that year (i.e., for the 2016 tax year IRA contributions must be made by April 17th, 2017). Contributions to IRAs are tax-deductible, unless the depositor’s income exceeds certain levels that depend on whether you are a single or married filer, if you are covered by a retirement plan at your place of employment, and your filing status. Find out if you are eligible to make a tax-deductible IRA contribution by visiting tinyurl.commagiira.
Financial aid affect
Like other retirement accounts, assets held within a parent’s IRA are not included in the federal financial aid formula, and therefore will generally not reduce any need-based aid awarded to the student by the school. But as with contributions to those other retirement accounts, contributions made to IRAs during years that the family is using to apply for financial aid will be added back in to the parents’ income, and will reduce need-based aid by as much as half of the amount contributed. Therefore, it’s best for families counting on need-based aid to maximize contributions to retirement accounts before the kids go to college, and then perhaps reduce or eliminate contributions while the children are in school so that there is as much money available as possible to pay for any uncovered costs.
Using an IRA for college
IRAs can be tapped for any reason after the owner reaches age 59 ½, and the amount withdrawn will be added to the IRA owner’s taxable income. If the IRA owner is under age 59 ½, withdrawals can still be made at any time. But the amount will not only be taxed as ordinary income, but will also be hit with a 10% penalty—unless the withdrawal is made to pay for certain qualified expenses. Expenditures in this category can include medical expenses and the down payment used by a first-time homebuyer. But they can also include college costs. Even if you’re under age 59 ½, you can use your IRA money penalty-free (but not tax-free) to pay for the tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. You can also use the funds with no penalty to pay for room and board, as long as the student is enrolled for at least half-time at a qualified institution. The student can be you, your spouse, your children, or any descendants of the qualified individuals (for instance, you could use your IRA penalty-free to pay for your grandchildren’s college costs).
Timing it right
Parents planning on tapping IRAs to pay for higher education expenses while applying for financial aid should know that the distributions will be included as “income” incurred during the year of the withdrawal, and therefore could reduce need-based aid awarded to their child. Thus it may be best to use the IRA funds to pay for only the final year of the kid’s college education, after which you (hopefully) won’t be applying for financial aid again.