Can You Use an IRA to Pay for College?

Individual Retirement Accounts (IRAs) are primarily designed for retirement savings, offering tax advantages for long-term wealth accumulation. While intended for retirement, specific provisions allow for IRA withdrawals to cover college expenses. Understanding these rules is important for anyone considering this option for financing higher education.

IRA Withdrawals for Education Expenses

Individuals can withdraw funds from their IRAs for qualified higher education expenses without incurring the usual 10% early withdrawal penalty that applies before age 59½. This exemption applies to both Traditional and Roth IRAs. The withdrawal amount cannot exceed the total qualified education expenses paid in the same tax year.

Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. If the student is enrolled at least half-time, room and board expenses also qualify. An eligible institution is any college, university, vocational school, or other post-secondary institution eligible for federal student aid programs.

The beneficiary of these penalty-free withdrawals can be the IRA owner, their spouse, or any child or grandchild. Maintain thorough records of all qualified education expenses to substantiate the penalty exception. When filing tax returns, report these distributions and claim the exception on IRS Form 5329.

Tax Treatment of Education Withdrawals

While the 10% early withdrawal penalty is waived for qualified education expenses, income tax implications depend on the IRA type. Traditional IRAs are funded with pre-tax contributions, meaning contributions and earnings grow tax-deferred. Withdrawals from a Traditional IRA are generally subject to ordinary income tax in the year of withdrawal, even if used for qualified education expenses and exempt from the early withdrawal penalty.

Roth IRAs operate differently, as contributions are made with after-tax dollars. Original contributions to a Roth IRA can be withdrawn at any time, for any reason, tax-free and penalty-free. If a Roth IRA withdrawal includes earnings, those earnings are also tax-free and penalty-free if the distribution is “qualified.” A qualified Roth distribution requires the account to be open for at least five years and the account holder to be at least 59½ years old.

However, if Roth IRA earnings are distributed before the five-year holding period or before age 59½, they may be subject to ordinary income tax, even if the 10% early withdrawal penalty is waived for education expenses. It is important to distinguish between the penalty waiver and income tax assessment. Income tax on Traditional IRA distributions and non-qualified Roth IRA earnings still applies.

Effect on Financial Aid Eligibility

Funds within an IRA generally do not impact federal financial aid eligibility. IRA assets, whether Traditional or Roth, are typically not counted as parental or student assets on the Free Application for Federal Student Aid (FAFSA). This exclusion allows retirement savings to remain outside the financial aid calculation for asset assessment purposes.

A significant consideration arises when funds are withdrawn from an IRA. Distributions, even if used for qualified education expenses and exempt from the early withdrawal penalty, are generally reported as untaxed income on the FAFSA. This income is reported for the “prior-prior year,” meaning a withdrawal in one tax year will affect financial aid eligibility for the academic year starting approximately a year and a half later.

IRA withdrawals as untaxed income can substantially increase the Expected Family Contribution (EFC), the amount colleges determine a family can afford to pay for education. A higher EFC typically results in a reduced financial aid package. While parent income is assessed at a lower rate than student income in the EFC calculation, any IRA withdrawal will be factored into the overall income assessment. Families may strategically time withdrawals to minimize this impact, such as taking a larger distribution in a single year to affect only one FAFSA cycle, or waiting until the student’s final year of college.

Other College Savings Vehicles

Beyond IRAs, several other tax-advantaged savings vehicles are designed to help families save for educational expenses. Two prominent options are 529 plans and Coverdell Education Savings Accounts (ESAs), each offering distinct features for college funding. These alternatives can complement or serve as primary savings strategies for education.

529 plans, also known as Qualified Tuition Programs, are state-sponsored investment accounts. Contributions are not federally tax-deductible, but earnings grow tax-deferred, and qualified withdrawals for education expenses are entirely tax-free. Qualified expenses are broad, including tuition, fees, books, supplies, equipment, and room and board at eligible institutions. Some states offer tax deductions or credits for contributions to their plans, and many plans also allow for up to $10,000 per year in K-12 tuition expenses.

Coverdell Education Savings Accounts (ESAs), formerly known as Education IRAs, are another tax-advantaged option. Contributions to Coverdell ESAs are limited to $2,000 per beneficiary per year and are not tax-deductible. However, like 529 plans, earnings grow tax-free, and qualified withdrawals are also tax-free. A notable feature of Coverdell ESAs is their flexibility, as funds can be used for both qualified higher education expenses and qualified elementary and secondary school expenses, including tuition, books, and even tutoring. Coverdell ESAs also have income limitations for contributors and require funds to be used by the beneficiary’s 30th birthday.