Do You Know About the IRA Education Loophole?

By Matthew Frankel Markets Fool.com

In most cases, if you withdraw funds from an IRA before you reach 59-1/2 years of age, you'll have to pay the IRS a hefty early-withdrawal penalty. However, there are a few exceptions, and one of the most valuable loopholes is the ability to withdraw from your IRA to pay for college expenses. Read on for more details and a look at whether an IRA could be a better savings vehicle than a more traditional college savings account.

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The general rule for IRA withdrawals

Funds you deposit into an IRA generally cannot be withdrawn before you reach age 59-1/2 without being assessed a 10% early-withdrawal penalty from the IRS.

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There are a few exceptions to this rule. For example, you can withdraw IRA funds early if you become totally and permanently disabled, or to pay health insurance premiums while you're unemployed. Another notable exception is a one-time withdrawal of up to $10,000 to be used toward a first-time home purchase.

However, perhaps the most lucrative loophole is the exception for educational expenses.

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The IRA education loophole -- a big exception

Under certain conditions, you can withdraw money from your IRA early to pay for qualified higher education expenses.The expenses must be paid for you, your spouse, or your child or grandchild, and they must be paid to an institution that is eligible to participate in federal student loan programs -- which includes virtually any postsecondary institution in the U.S.

The IRS defines qualified higher education expenses as:

  • Tuition
  • Fees
  • Books
  • Supplies
  • Equipment required for enrollment or attendance
  • Special needs services required in connection with enrollment or attendance
  • Room and board (if the student is enrolled half-time or more)

While expenses that meet the requirements are exempt from the 10% early-withdrawal penalty, you may have to pay income tax on the money you withdraw, depending on the type of IRA and whether the money came from your contributions or from investment profits.

Should you use your IRA as a college savings account?

Technically, IRAs are designed for retirement savings, not for college planning. However, many people use IRAs, particularly of the Roth variety, as alternatives to other college savings vehicles such as the 529 savings plan or the Coverdell ESA.

For starters, Roth IRA contributions (but not earnings) can be withdrawn at any time, and for any reason, without penalty. For example, if you've contributed a total of $30,000 to a Roth IRA and your account is now worth $100,000, you can withdraw the original $30,000, no questions asked. This can be especially useful for college savings, as you are not limited to the IRS' definition of "qualified higher education expenses" with this portion of your account. If you want to pay for an otherwise unqualified expense, such as a car for your child to get to and from school, go for it.

Also, Roth IRA accounts don't count as assets when your student fills out the FAFSA, so this form of college savings does not affect their ability to qualify for other types of financial aid.

Finally, when you save for college with an IRA, you're not necessarily committing to using those funds for college. With a 529 plan, for instance, any withdrawals must be used for qualified education expenses, or you'll probably owe a penalty. Meanwhile, if you don't need your IRA funds to pay for education, you can simply leave the money alone to grow until you're ready to retire.

The bottom line is that while IRAs aren't officially "college savings" accounts, they can certainly be useful for this purpose -- as long as you're not counting on your IRA investments to fund your own retirement. If you want more information about opening an IRA or investing in an IRA, check out The Motley Fool's IRA Center.

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