Traditional & SIMPLE IRAs

The $5,500 deduction of a traditional IRA can shelter the investment income of a student in pre-college years, assuming the student has wages or other earned income at least equal to the IRA amount. This strategy has the effect of deferring other investment income to college years. The student then withdraws the IRA to pay college tuition, and uses education credits to offset the tax on the IRA withdrawal.

Under IRC Sec. 72(t)(2)(E), an exception exists to the 10% early withdrawal penalty for IRA withdrawals when the distribution is used to pay for qualified higher education expenses. Qualified education expenses include tuition, fees, books, supplies and equipment. Room and board are also included if the student is enrolled on at least a half-time basis. These education expenses must be reduced by any IRC Section 117 tax-free scholarships or grants, IRC Section 135 qualified U.S. Series EE Bond, veteran’s education benefits, and other tax-free educational benefits.

To be eligible for the penalty free IRA distribution the student must be the taxpayer, the taxpayer’s spouse, or any child or grandchild of the taxpayer or the taxpayer’s spouse. The distribution must be used to pay for qualified education expenses. Tax-free distributions from a CESA, qualified U.S. EE Savings bond, or employer-provided educational assistance will reduce the amount of qualified education expenses for the penalty free IRA distribution.

Roth IRAs

A Roth IRA may be a good college investment option. The advantages are:

  • it is a non-assessable asset in the EFC computation,
  • the earnings grow tax-free,
  • early withdrawal of only the contributions will be tax-free,
  • current year contributions will not prevent a contribution to a tuition prepayment savings plan,
  • withdrawal from a Roth IRA will not affect eligibility to claim the Hope Credit or Lifetime Learning Credit nor will it reduce the “qualified education expenses” for the student loan interest tax deduction,
  • no taxability of withdrawals of contributions if used for non-college purposes,
  • control of the asset remains with the parent,
  • up to $5,500 per year may be contributed by each parent, and
  • with proper tax planning, the child may be able to contribute $5,500 annually to the child’s own Roth IRA.

If it is possible that the child would have more funds than needed for college when measured during the later teen years, the Roth IRA may be used in lieu of funding additional QTP amounts. The Roth IRA does not need to be consumed for college as do QTP amounts, but has essentially the same tax result. Roth IRAs can be used for first-time homebuyer costs, another shorter term use, rather than postponing withdrawal until retirement.

A client can make a nondeductible contribution of $5,500 if the client is single and has an adjusted gross income (AGI) less than $118,000.

Married taxpayers are able to make contributions of $11,000 if their combined AGI is less than $186,000. The money grows tax-free and withdrawals are accessed under the First-in, First-out basis (FIFO). This means that funds withdrawn are tax-free to the extent of the sum of the original contributions to the Roth IRA.

Investment income from Roth contributions are also tax-free if they are held for five years and the IRA owner is age 59½ or older when distributions begin. With regular IRAs, the income is only tax-deferred.

Another favorable feature is that Roth IRAs are not subject to the minimum distribution rules (70½) that apply to regular IRAs.

Teenagers who work part-time and have earned income during the year qualify to open a Roth IRA. Parents can contribute up to $5,500 as a gift as long as the child has at least $5,500 in earned income that same year. A Roth IRA is more efficient than a traditional IRA if the child does not have taxable income.