Don’t raid an IRA to pay for college

Overwhelmed by the wide range of potential savings vehicles for college, consumers often default to what they know, namely familiar retirement accounts. In fact, 24% of college savers use retirement accounts as college savings vehicles, according to Sallie Mae.

That can be a mistake.

Investors who are saving for a child's college expenses and their own retirement are planning for two distinctly different events, which call for distinctly different savings strategies. A retirement account shouldn't act as a catchall.

Generally, withdrawing money from a traditional or Roth individual retirement account to pay for college should be considered only as a last resort, as the vehicles are built for retirement.

Investors may want to tap their IRA for college expenses because they know that such plans allow for funds to be withdrawn to pay qualified higher-education expenses without the 10% penalty. Although this is true, this strategy falls short for a number of reasons.

Perhaps the most obvious reason is that a dollar withdrawn is one less dollar available for retirement. Once removed, the money can't be put back.

The only way to rebuild the balance is through normal contributions, which are subject to annual limits.

TAX CONSIDERATIONS

It is important to review with clients the tax implications of using a traditional IRA for college savings. With the elimination of the early-distribution penalty for costs associated with qualified higher-education expenses, a traditional IRA more or less becomes a tax-deferred college savings vehicle.

Funds in a traditional IRA are sheltered from the financial needs analysis and, as such, don't affect eligibility for financial aid. This benefit, however, is outweighed by a number of disadvantages.

Timing of distributions is one issue. The distribution must occur during the same year in which the qualified expenses are paid, meaning that the account holder can't withdraw the funds a year before or afterward.

For example, if a student is planning to register for the spring semester, his or her tuition might be due in December of the previous year. A traditional IRA thus cannot be used to cover these tuition costs.

In addition, qualified education expenses can be used to justify only one education tax benefit. If these expenses are used to justify a penalty-free withdrawal from an IRA, the account holder can't use the same expenses to justify a Hope Scholarship or Lifetime Learning tax credit.

A Roth IRA isn't the most suitable option for college savings, either. With a Roth, earnings can only be distributed tax-free after the account owner reaches 591/2 and after the money has been in the account for at least five years.

If any variable of that equation changes, all the account earnings are taxable — including those used for college expenses.

Roth IRAs also can lower the amount of financial aid for which a student may be eligible. The year after a distribution has been made, it must be included as part of the student's base-year income on the federal-aid application.

A stronger base-year income can negatively affect a student's likelihood of receiving need-based financial aid the following year. Students who receive aid for their first year may find that they are ineligible for aid come sophomore year.

Another negative with a Roth IRA is that contributions are limited to $5,000 per year. This hardly makes this type of vehicle one that can help achieve both one's college and retirement savings goals.

Also, there are income limits restricting IRA contributions.

In 2011, married couples filing jointly can contribute the maximum only if their modified adjusted gross income is $169,000 or less. For single filers, the income limit is $107,000.

529 PLANS OVERLOOKED

As simple as it seems, far too many consumers overlook vehicles such as Section 529 savings plans that are specifically designed for college savings. Because savings grow tax-deferred and distributions are tax-free at the federal level, among other benefits, a 529 is generally a more suitable college savings vehicle than a traditional or Roth IRA.

Though saving for both retirement and college is a colossal challenge, by taking the time to educate clients about the downside of using the wrong vehicles for college saving, you can help cement solid relationships by helping them hold on to their hard-earned nest eggs.

Nancy Farmer is president of the Private College 529 Plan.

Related Topics: ING Group