Pros and Cons of Using Retirement Funds to Pay for College Costs
October 03, 2011
There are, however, a few workarounds.
If the family does not qualify for need-based financial aid, then the only consideration is the potential tax liability. This may make a Roth IRA an attractive vehicle for college savings, since the return of contributions is tax-free. The money in a Roth IRA can be used for retirement if the child does not go to college or if there are excess funds in the Roth IRA account. However, most families have a tendency to underestimate their eligibility for need-based financial aid, so this approach should be used with caution.
If the family takes a distribution from their retirement plans in the student’s last year in college after filing the FAFSA, or after graduation, there may be no impact on eligibility for need-based financial aid. Depending on the timing, the family may be able to avoid the 10% tax penalty. The student might use the distribution to pay off his or her loans. If the distribution consists entirely of a return of contributions from a Roth IRA, it can also avoid any tax liability.
However, the parents need to be careful about the timing of the distribution if they have another child who will be enrolling in college.
Retirement plan distributions might affect the student’s eligibility for financial aid for graduate or professional school if the student enrolls immediately after graduating from undergraduate school. Distributions from the student’s own retirement plans during the senior year will be treated as income on the subsequent year’s FAFSA. Similarly, distributions from a parent’s retirement plan that are used to pay for college costs may be treated as untaxed income to the student on the subsequent year’s FAFSA since graduate students are automatically independent. While cash support from a parent to a dependent student is ignored on the FAFSA, cash support from a parent to an independent student is treated as untaxed income to the student.
See Retirement Plans and Saving for College on the FinAid site for additional details.