<h3>Overview:</h3>There has been a lot of buzz about using an IRA, especially a Roth IRA, as an alternative type of college savings account. The basis for this idea is that IRA’s allow you to avoid the 10% early withdrawal penalty if used for qualified college expenses.<p>The avoidance of this penalty is often confused with the avoidance of income taxes. These withdrawals will not avoid normal income tax on funds that are previously untaxed, regardless of whether you withdraw them from a Traditional or Roth IRA.</p><p>Using a Roth or a Traditional IRA is an advanced financial planning strategy that requires numerous questionable assumptions, and is generally not recommended. The benefits of this technique are comparable to the benefits of using a Section 529 Savings Account or a Coverdell ESA.</p><h3>Ideal Investor:</h3><p>Investing for college in Roth or Traditional IRA should be evaluated when a number of the following conditions are present:</p><ul><li>A parent is sophisticated in their understanding and knowledge of tax rules. </li><li>Retirement objectives are already being met sufficiently through other plans. </li><li>The parents or child are eligible to contribute to an IRA. </li><li>They will not get financial aid if they show any college savings. </li><li>They have already maxed out other college savings options, or are not eligible based on their income. </li><li>They will not likely need to withdraw more than their original investment. </li><li>They want to retain final control over unused assets. </li></ul><h3>Potential Advantages:</h3>Perhaps the biggest potential advantage to using an IRA is that retirement plan assets are not included in most financial aid calculations. If an identical amount of money is saved in a Coverdell ESA or Section 529 account, 5.64% of its value will count against financial aid each year.<p>Another advantage is that unused funds, if held in the IRA until normal retirement age (at least 59 1/2), will not be subject to a 10% withdrawal penalty. In the case of a Roth IRA, they will not be subject to income tax, either.</p><p>This stands in contrast to the 10% penalty (plus incomes taxes) levied against unused Section 529 or Coverdell ESA funds when they are withdrawn.</p><h3>Potential Disadvantages:</h3>There are numerous disadvantages to this strategy as well. Perhaps the biggest is the loss of the use of an IRA for your annual retirement savings. Using a retirement IRA to save for college costs you the opportunity to use it to save for your future. Since retirement will be much more costly than a college education, this is a key consideration.<p>Another disadvantage will be the taxation on withdrawn funds. In a Traditional (deductible) IRA, the entire withdrawn amount will be subject to Federal and state income tax. In a Roth IRA, any funds withdrawn above and beyond your original contributions will be taxed at a Federal and state level.</p><p>When this is compared against the tax-free withdrawals permitted for Section 529 plans and Coverdell ESA’s, this can represent a significant waste of money.</p><p>For example, a $20,000 taxable withdrawal for qualified expenses from either type of IRA might easily cost $5,000 in taxes (assuming a 25% Federal and 5% state tax rate). This same withdrawal from a Section 529 or Coverdell ESA account would be tax free.</p><h3>Investment Options:</h3>Permitted investments for IRA’s include the full menu of individual stocks, bonds, CD’s, and mutual funds. In addition, annuities can be purchased in IRA’s, but generally should be avoided.<h3>Tax Benefits:</h3>The big advantage of any type of IRA is the tax-deferred growth. In other words, you do not have to pay tax each year on the interest, income, and growth of your investments. This helps super-charge your growth rate even if you have to pay the tax later, as is the case with the Traditional IRA.<p>However, this benefit is partially lost when money is withdrawn for education expenses. Though the IRS waives the 10% penalty for an early withdrawal, you are still liable for income tax on money that has never been taxed elsewhere. This would mean any money withdrawn from your deductible IRA, and any gains from a Roth IRA, would be hit with income taxes.</p><h3>Eligible Expenses:</h3><ul><li>Tuition at the college level or higher (but not room and board) </li><li>Books, equipment, and fees (if required by the school) </li></ul><h3>Effect on Federal Financial Aid Eligibility:</h3>Money held in retirement accounts such as a Traditional or Roth IRA does not need to be reported on the Federal FAFSA form. Thus, it will not hurt financial aid eligibility.<h3>Eligibility:</h3>Withdrawals that avoid the 10% early withdrawal penalty must be for the education of the account owner, their spouse, children, or grandchildren.<h3>Contribution Rules:</h3>There are complex contribution rules for IRA’s which are affected by the type of IRA, a contributor’s age and income, and whether or not the contributor or their spouse is offered a retirement plan by their employer.<p>The maximum contribution to an IRA is $5,000 per person, with an additional $1,000 for account owners over age 50.</p><h3>Contribution Deadline:</h3>The contribution deadline for an IRA is a taxpayer’s filing deadline, which is generally April 15th plus extensions.<h3>Withdrawal Rules:</h3>As previously mentioned, IRA withdrawals before age 59 1/2 may be subject to income tax and a 10% penalty. The 10% penalty is waived for qualified higher education costs, but any withdrawals of previously untaxed money are still subject to income tax.<h3>Treatment of Unused Funds:</h3>Unused funds remain the property of the parents for as long as they choose. However, Traditional IRA’s (not Roth IRA’s) are subject to Required Minimum Distributions starting at age 70 1/2.