The ABCs of Using the Roth IRA to Cover Education Costs - TheStreet

The ABCs of Using the Roth IRA to Cover Education Costs

In many ways, it's a better deal than the Education IRA.
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I received a lot of great questions following last week's

column on Roth IRAs. Many were about educational funding. Reader

Jim Sullers

, for example, asks: "I was under the impression that I could withdraw funds from my Roth in order to pay for my children's college tuition -- is this true?" Several of you had similar questions, so I am devoting today's column to trying to help you pay for your children's and/or grandchildren's education. I think it is one of the more underplayed benefits of the Roth IRA.

The law allows you to withdraw money from your Roth IRA to pay a qualified higher-education expense for you, your spouse, your child or grandchild, or your spouse's child or grandchild.

What are qualified expenses? They include tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. Room and board also qualifies if the student is enrolled at least half-time. The amount allowed for room and board is generally the school's posted charge, or $2,500 per year for students living off campus and not at home.

The problem with the Roth IRA is that every definition seems to spawn another one. What is an eligible educational institution, you ask? The definition is quite broad. It includes virtually all accredited public, nonprofit and proprietary postsecondary institutions. That means just about any college or university -- even a vocational school.

Now, let's talk taxes. These education withdrawals -- or "distributions," to use the language of the law -- are an exception to the 10% premature-distribution penalty that applies to many other types of Roth IRA withdrawals. That's the good news.

The bad news is that these withdrawals are not entirely tax-free. Your contributions aren't taxed when you withdraw them, but the earnings on those contributions are. Keep in mind, though, that the first money taken out of a Roth is considered contributions. This is often referred to as the first-in, first-out, or FIFO, accounting rule.

One big advantage to these educational withdrawals is that there's no dollar limit. You can withdraw and spend as much as you want on qualified expenses. Withdrawals to pay home-buying expenses, on the other hand, are limited to $10,000 per lifetime.

This makes the Roth IRA a much better deal than the Education IRA. You can contribute up to $2,000 annually to a Roth IRA, but only $500 a year to an Education IRA. Even if you contributed $500 a year, and earned 12% on that money for 18 years, you would only have about $28,000 in an Education IRA. You'll be lucky if that covers the cost of one year of tuition 18 years from now.

Even though all distributions -- contributions as well as earnings -- are tax-free in Education IRAs, it is a relatively small bone

Congress

has given us, so you will need more money. The question is how to most effectively get it.

That's where Roth IRAs come in. Of course, you have to weigh your own retirement needs against the options of withdrawing money for educational purposes.

The $2,000-a-year individual Roth IRA contribution ($4,000 per couple) adds up to $36,000 for one person and $72,000 for both parents over 18 years just from contributions. At an earnings rate of 10% compounded annually over 18 years, each parent would have about $91,000. For two parents, that adds up to $182,000. Remember, the $72,000 in original contributions can be used for education expenses without tax or penalty.

Depending upon your situation, you may be able to help fund educational expenses with your original contributions and at the same time help fund your retirement with the tax-free earnings. Of course, if you decide to withdraw some of the earnings for education, you will pay income taxes but no 10% penalty.

The Roth IRA also has the benefit of being in the name of the parent so it doesn't count against a child seeking financial aid.

For more on funding education, see my Sept. 16, 1998, column,

Saving for College -- When, and How.

As usual, I welcome your email. Please note my new address:

Hayden4t9@aol.com.

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at

Hayden4t9@aol.com.