Best Way to Save and Pay for College?

publication date: Feb 20, 2009
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Q: My husband and I have the bulk of our savings in a retirement account invested in mutual funds.  We contribute the maximum amount, based on his income, allowed each year. We also have substantial equity in our home.  We are in our forties, and our first child will be college bound in five years.  I understand the law allows withdrawals from some IRA's for higher education fees. Will we be penalized if we withdraw money from the IRA account to help pay our children's education? Is there a better way for us to save money for both education and retirement purposes?


A: IRAs do allow for penalty free withdrawals under certain circumstances prior to age 59 ½. Normally, withdrawals before that age are subject to a 10 percent federal tax penalty plus whatever penalties your state assesses.

You may make penalty-free withdrawals from IRAs for qualifying higher educational expenses, which includes costs such as tuition, fees, books, and supplies. However, and this a big however, please recognize that you must still pay current federal and state income taxes on your IRA withdrawals. Since you are still in your working years, income taxes could easily gobble a third or more of your withdrawals. And, once withdrawn, you will not have that money compounding for your future years.

Saving money outside retirement accounts may provide you with more cash to immediately pay college expenses however, doing so can dramatically decrease your child's financial aid awards, especially if the money is invested in the child's name. By contrast, money inside your retirement accounts does not count against financial aid.

You may contribute up to $2000 per year per child to an Education Savings Account (ESA) which like a Roth IRA, allow for income tax-free withdrawals subject to meeting certain requirements. Money in an ESA is generally treated as a parent's asset until the student reaches his state's age of majority (which is either 18 or 21 depending you're your state) at which point the money is considered the student's asset.

For all the details as to how various financial moves affect your college financial aid, please be sure to read my complete summary of Kal Chany's excellent book Paying for College Without Going Broke.



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