Tapping an IRA for College Expenses

Paying for College
1

<p>i know this is heresy in the financial planning world, but this strategy has been the one that has worked for our family so I thought I would throw it out there to see if it has merit for other families in the same boat...</p>

<p>I have an IRA that I contributed to for about 5 years beginning right when I got out of college (I then pretended to "forget" about it). Due to amazing growth over 22 years, by the time my oldest child was ready for college it was ~$160k. Current tax law allows us to draw money out penalty free (but not income tax free) for our kids college expenses including room and board. The last 3 years we have taken out ~$16k per year. With the huge tax credits for the American Opportunity Act for tuition/books/fees and multiple children in college (plus younger children still qualifying for the child tax credit) even the marginal tax rate on the extra cash drawn from it is only 15%. If we hadn't taken the money out we might have even lost a little of the non-refundable part of the credit. With the way the US tax rates have to be heading, and with all our " deductions" grown and graduated from college, I am sure our marginal tax rate will be much, much higher in retirement.</p>

<p>My big concern is both the American Opportunity Act and the Child Credit are scheduled to expire at the end of 2012!</p>

<p>BTW, we do have other retirement savings accounts for our actual retirement. (Do to generous company matching policies we are still contributing to them)</p>

2

<p>There are very few hard and fast rules about anything,but tapping into an IRA or other qualified plan can cause all sorts of complications for people. If your are applying for financial aid, those distributions are counted as income. If you are not careful, the distributions can bump you up into categories where you can lose some credits and deductions. </p>

<p>I opted to take out loans rather than touching an IRA. The interest on the loans are deductible, there are no increases in the income for any other programs, the money remains in the IRA earning a bit of tax exempt interest, and you still get all of the tax credits and pay less taxes because your income is lower. If, when all is said and done, there is not the income to pay the loans, I would then raid that IRA rather than doing it up front. I don’t like loans and my record in discussing them will show that I caution people about taking them, but if I had an IRA I was willing to “Raid” for the tuition, I would use it as back up to pay off the loans. </p>

<p>Hard to say if the AOA and Child Credit will not be extended.</p>

3

<p>Like I said in the original post - this strategy is not for everybody, but I think it is a viable option for a narrow group of families that may have situations similar to ours so I wanted to throw it out here because I have never seen it suggested before. </p>

<p>Most of the minuses of IRA withdrawal don’t apply to our family. We are well under a six figure income so the income caps for various tax deductions won’t affect us with the additional AGI. Our base income is already too high for Pell. Our kids are only applying to schools that don’t provide need-based aid, only merit aid. Paying taxes on it as ordinary income hurts, but that will happen whenever we take it out. Most importantly, without this IRA we are still on track for funding our retirement. </p>

<p>The pluses are we don’t have the income to add loan payments to our monthly budget. Our family (my husband, I, and our kids) feel pretty strongly about our kids not having student loan debt if it can be helped. There is no early withdrawal penalty if the funds are used for current year room and board. Our marginal tax rate (assuming nothing catastrophic happens) will never be lower than it is right now. </p>

<p>We want our children to be able to “go away” to school if that is what they want. This strategy (in conjunction with other strategies: dual enrollment, CLEP, applying to lower tier schools to get merit aid, etc. ) has provided a way for that to happen.</p>

4

<p>Interesting. I never thought about this.</p>

<p>Due to us having a business and rental properties as well as relatively high income, my children probably will be full pay at any college, even “meet need”. So, distributions as income do not matter in our case. </p>

<p>Most of our assets are in rental properties, 401K and Sep-IRAs. </p>

<p>I already informed my son that he probably will be attending in-state flagship because I don’t feel like paying 50-60K a year for a private. That being said, he is really interested in MIT, so if does get in (very unlikely) and if I think he is mature enough to be in a school like that, I might want to consider tapping into SEP-IRA. </p>

<p>The only reason why I would consider this is because I also have 401K and traditional pension from my employer as well as rental properties. If I only had IRAs, I would not even think about it.</p>

5

<p>This is the sort of thing where an accountant would be useful. You pay what percent of what you took out of your IRA in taxes? If you borrow, after deducting the interest what percent are you paying . That is one comparison. Also, are you being knocked into another tax bracket, losing any benefits from being upper income, such as possible no interest loans on the Staffords? If one of your kids applies for financial aid in a subsequent year, how is that additional income affecting his aid package and other scholarships and programs with a need component?</p>

<p>An example: You take out $16K to pay for your Student 1. That incurs that much more income that year which can result in an additional $4K in taxes at a 25% marginal rate. Yes, your tax credits might wipe that out, ,but they would have still kicked in and further lowered your taxes with out that additional $16K kicker. Your second child decides to apply to some schools that guarantee to meet 100% of need. So that second year when you are filling out the PROFILE and FAFSA, you have to report $16K more in income which is going to bring up that EFC and PROFILE contribution up another $4_6k at least. Even if a school is not meeting all need you don’t know if they’ll throw in some money as financial aid and at what thresh hold or what formula they use. My cousin’s son got $5K from his state school in need based money. If their income had been up another $17K, who knows if they would have even given him anything. You only know what happens in the circumstances you report so, it’s really impossible to guess. Had the family, borrowed the $16 instead, the interest on it would have been about half what the tax on it was, and not assessed for another year. If the kid took out the loan and it qualified as need, $3500 of it would have been interest free and remained so until after he graduated, and then assessed at whatever his tax rates happen to be as he repays it. </p>

<p>There are merit within need or need within merit awards that a student qualifies if he simply has financial need. Amount not specified. Just have to have need. You don’t know if your kid(s) are being checked to see if they qualify. </p>

<p>My kids borrow the full Stafford they can each year, since we want to borrow but they get a lower interest rate than we do, it’ll help their credit to have the loan pai timely way and they might be able to deduct the interest as we are not able to do so. If they had any need at all, I would certainly have them borrow because that is an interest free loan while they are in school, not to mention a great interest rate thereafter for the subsidized loans. </p>

<p>The other thing is if you take out student loans and die, the loans are done. No one owes. So they have that bit of insurance to them. My friend’s DH was in his 60s when they had kids. He took out a slew of loans, including some very huge amounts for one of the girls to go to Columbia journalism school, and passed away after paying only a small amount on them. Had he used his assets in his pension/IRA whatever accounts, his family would be poorer by 6 figures. </p>

<p>Again, I’d prefer a tax professional to say, one way or the other, as it is often not simple to make these decisions. There is no way i would want to increase our taxable interest I can see. But it is certainly possible that this is the best way to go for some people.</p>

6

<p>Yes, I would calculate everything before I take out anything out of IRA. </p>

<p>The one thing I wish I could do is to contribute to Roth IRA. You can take out principal any time without any tax repercussions (while interest continues to compound tax free). But we cannot not because of income limitations.</p>

<p>I always advise people to contribute to Roth IRA if they can afford it. Depending on the income and amount of contribution, some of those contributions become free money because of the refundable tax credit for savers. It is almost like a tax-free savings account from which you can withdraw principal at any time (but you cannot withdraw interest until you are eligible to retire).</p>

7

<p>Don’t withdrawals from a Roth IRA count as income on Financial aid apps? </p>

<p>It is not easy dealing with all of this. Even with an accountant. Our accountant is great with tax issues but is not up on financial aid issues. I don’t see too many accountants who have a good grasp of that.</p>

8

<p>Lerkin, you can get around income limitations on Roth contributions by contributing to a nondeductible Traditional IRA and then converting it to a Roth soon after. Because you got no benefit for contributing to the IRA initially, there are no tax consequences to the conversion. </p>

<p>It’s a little more complicated than I’ve made it sound, but it’s doable if you’re motivated. Here’s a step by step process…[Backdoor</a> Roth: A Complete How-To](<a href=“http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html]Backdoor”>Backdoor Roth: A Complete How-To)</p>

9

<p>Been reading this thread with great ‘interest’, no pun intended. :)</p>

<p>It’s frustrating to have the money to pay for college but not being able to zero out that debt because of tax ramifications from withdrawal–early or not–from a traditional IRA, thus the necessary introduction of the Parent PLUS loan. And the only way to stay ahead of the whole deal has been to make sure one is earning more than 6.8% in the IRA, which hasn’t been an easy task.</p>

<p>Obviously, the 10% early withdrawal penalty has been rendered a moot point (not enforced if used for ed expenses), but it’s the taxation of the withdrawal as ordinary income that’s a killer, especially when I will be working–hopefully–for the foreseeable future, with retirement still way down the road unfortunately. So I have left it alone.</p>

<p>I also have a variable term insurance policy that was partially invested in the metals market before the gold run-up that has done very well and has tangible cash value. I have been told by the agent & other online sources that I can ‘borrow’ a portion from those assets with only a 1% net fee & NOT have it count as ordinary income when withdrawn. If true, I could in theory pay off some of that 6.8% PLUS loan money that is accruing like a cabbie’s meter, and be money ahead. I have not pulled the trigger on this either, because if this information is wrong, I highly doubt the 20-something insurance agent purporting this strategy would own up to his error & make up the difference for me!</p>

<p>Cptofthehouse is right. It is very difficult to find a good accountant, especially one schooled in the ever-changing world of financial aid strategies. And, I’ve found that the couple of accountants I’ve spoken with won’t take my business strictly on a tax advisory basis–they want to manage my investments too. Uh, sorry, no.</p>

<p>So my plan is now that tax day has almost passed, I will be more aggressive in trying to find an accountant that fits my qualifications & has the time now to want my business on my terms.</p>

10

<p>Yeah, I tried to “back door” my paltry IRA that I put away the year DH was on his own. Without coming up with a 401K “front”, I can’t do it. Wish I could.</p>

11

<p>GAMom - thank you for the post. I am thinking about tapping into an IRA as well. I read through the tax law and it appears that I can withdraw without penalty. I am happy to hear you were able to make it work.</p>