IRAs, or individual retirement accounts, are a valuable long-term savings tool, particularly for workers who don’t have access to a 401(k) through their jobs.
If you’re saving in a traditional IRA, you’re probably aware that the money in that account is meant for retirement, and there are penalties associated with withdrawing funds prior to age 59 and 1/2.
The IRS will allow you to take an early withdrawal from your IRA of up to $10,000 to purchase a first-time home.
It will also allow you to withdraw funds prematurely from your IRA to pay for college — either for yourself, your spouse, your child, or even a grandchild.
Whether or not it makes sense to tap into your IRA for college purposes, though, is a different story.
An interstate road said that says “IRA”; the letters IRA are in white against a blue background, and on top of the there’s a row of five white stars on a red background. Under the word IRA, with an arrow pointing to the right
What’s that money for?
If you open an IRA for the express purpose of socking money away for college, then there’s nothing wrong with taking withdrawals to cover higher education, provided you have another account somewhere earmarked for retirement.
But if taking IRA withdrawals for college means depleting some of the cash reserves you’ve been setting aside for your golden years, then doing so is a pretty bad idea.
The less money you have in your IRA by the time your career wraps up, the less income you’ll have access to in retirement. It’s that simple. Therefore, if you withdraw a chunk of your savings to pay tuition bills, you’ll be without that money at a time in your life when you need it the most.
Furthermore, remember that any time you take an IRA withdrawal, you don’t just lose out on the principal amount you remove; you also lose out on gains that sum could’ve produced.
Let’s say you take a $20,000 IRA withdrawal to pay for a child’s college 15 years before your targeted retirement date, and let’s also assume that your investments generally deliver a 7% average annual return. In that case, that $20,000 withdrawal will actually cost you $55,000 in lost retirement income.
An alternate solution
There’s nothing wrong with opening an IRA for the purpose of saving for college. The benefit of doing so is that your contributions will go in tax-free, thereby saving you money in the process of making them. The problem, though, is that with an IRA, your contributions are limited to whatever the annual maximum is. That number can change from year to year, but for 2019, it’s $6,000 if you’re under 50, or $7,000 if you’re 50 or older.
If you only have one child whose education you start saving for early on, an IRA might allow you to achieve your savings goals. But if you have multiple children and don’t start saving for college until they’re in their teens, you might come up short by only being allowed to set aside $6,000 or $7,000 a year.
Furthermore, while you do get a tax break for funding a traditional IRA, withdrawals are taxed as ordinary income, so the amount you take out to pay for college won’t be yours to keep in full.
A better solution, therefore, might be a 529 plan. With a 529, you’re not limited in what you can contribute annually, and while the money you put in doesn’t give you an immediate tax break at the federal level (there are some incentives at the state level, depending on where you live), once you fund a 529, your money gets to grow tax-free.
Withdrawals are then yours to take free and clear of taxes, provided they’re used for educational purposes.
Of course, the main drawback of 529s is that you’re restricted in how you can use your money. With an IRA, you can take withdrawals for college, or reserve money you don’t use for retirement. But if you do a good job of estimating your college savings needs, you might avoid a scenario where you overfund your 529 and run into that problem.
Tapping an IRA to pay for college is a move that can really hurt you if that money is supposed to be reserved for retirement. On the other hand, if you have separate funds for your golden years, a dedicated IRA might serve as a reasonable college savings solution.
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Source: The Motley Fool