As college costs continue to increase, parents are exploring every possible tool available to meet those costs. Roth IRAs can play a significant role, but the rules can be confusing. Before paying for college with your Roth IRA, make sure you understand the affect taxes will have.
Contributions and Conversions
If you’re considering using a Roth IRA to pay for college and only use contributions or converted funds, there’s good news. Your contributions are always tax and penalty-free. This includes withdrawals used to pay for college.
It gets a little more complicated when you withdraw money converted from a traditional IRA. If you’re younger than 59 1/2, the five-year holding rule usually applies. It says you must hold converted funds at least five years to withdraw them without incurring a 10% early distribution penalty. However, there is an exception when using the withdrawal for higher education. In other words, if you use converted funds from your Roth IRA to pay for qualified education expenses, those funds are always available to you without taxes or penalties. It doesn’t matter how old you happen to be or when your Roth conversion was done. It doesn’t hurt that under Roth IRA ordering rules, contributions and conversions are also the first money to leave your Roth IRA.
Under Roth IRA ordering rules, money you earn on contributions and conversions are the last to leave your Roth IRA. Because of this, withdrawals that include earnings is more complicated.
To be a qualified Roth IRA distribution of earnings, you must have held the Roth IRA for at least five years, and you must be older than 59 1/2. Exceptions apply to those who are disabled, purchasing a first home, or deceased. However, higher education is not a reason for a qualified Roth IRA distribution. Therefore, if you are younger than 59 1/2 and aren’t disabled, any portion of earnings you withdraw are taxable, but you aren’t subject to a penalty if used for higher education expenses.
Paying for College With Your Roth IRA
As mentioned earlier, paying for college with your Roth IRA can have tax implications and the rules can be confusing. For example, assume you’re 55 years old. You have a $20,000 Roth IRA. $18,000 of that is converted funds while $2,000 is earnings. If you take the entire distribution to pay for college, the withdrawal will be penalty free. However, you will be liable for taxes on $2,000 of the distribution.