Turn your 401k from a “tax deferred” to a “tax free” instrument – and use it to help pay for college. Early distributions for higher-education expenses escape the usual 10% IRS penalty. (Early distribution penalties also disappear once you reach 59½.)
Qualified expenses include tuition, fees, books, supplies, and a limited amount of room and board. However, penalty-free withdrawals aren’t necessarily the same as tax-free withdrawals. Check IRS Publication 590 to determine if your IRA withdrawals for college expenses need to be reported to the IRS.
Also, consider the impact of IRA withdrawals on your child’s financial aid eligibility. An IRA withdrawal — whether taxable or not — must be included as income on the following year’s FAFSA (Free Application for Federal Student Aid) application. Family income is a bigger determinant of financial aid than family assets, and withdrawing IRA funds can dramatically reduce your children’s financial-aid awards by increasing family income. (Seems odd, doesn’t it?)
For those reasons and because you want retirement accounts to last the rest of your lives, IRAs are not the best option for college funding.
Instead, earmark a ROTH account for potential college savings. Withdrawals are tax free under any circumstance and assets fall under the radar of any education-qualification measure.
On the other hand, withdrawals from a 529 plan will impact future financial aid treatment and won’t be tax free unless used exclusively for higher education expenses. (See 529 Broken Promises)
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