Does Taking Money From an IRA to Pay for Education Have Any Impact on Student Loans?

by Tom Streissguth

An individual retirement account, or IRA, is a tax-advantaged way to save for your retirement years. With either a traditional or Roth IRA, you can take advantage of tax savings either on your contributions (traditional) or your withdrawals (Roth). The Internal Revenue Service also allows you to take penalty-free withdrawals for education expenses. But if you have student loans outstanding, there are a few tax rules to keep in mind.

Early Withdrawals

Normally, any withdrawals from a traditional IRA before you reach age 59 1/2 incur a tax penalty of 10 percent -- over and above any income taxes you owe on the investment gain in the account. However, the IRS makes an exception for certain expenses, including education costs for yourself or for a dependent. These qualified expenses include tuition, fees, supplies and books, but do not include the repayment of student loan debt. If you repay a loan with your IRA withdrawal before the minimum retirement age, you are still subject to the early-withdrawal penalty.

Withdrawals and Student Loans

When you contract for a student loan, your lender establishes a repayment schedule that begins when you complete your education or withdraw from college. Any distributions you take from your IRA to help pay for the loan will not have any impact on the loan itself; the interest rate, monthly payment and amortization schedule for the loan remain the same. If you find it necessary to use IRA funds for this purpose, the early-withdrawal and income tax rules make it far better to rely on a Roth than a traditional IRA for this purpose.

Roth IRAs and Education Expenses

With a Roth IRA, your original contributions as well as the account earnings can be withdrawn tax free after you reach 59-1/2, and original contributions can be withdrawn at any time, tax-free. But if you withdraw money in excess of your contributions before age 59 1/2, then you will incur tax as well as an early-withdrawal penalty. While you can avoid the tax and penalty by using the money to pay qualified education expenses, the repayment of student loan debt does not qualify. Therefore, to avoid penalties and taxes, only withdraw your original contribution amount to repay the loan, if you need to draw from the Roth.

Qualifying for Financial Aid

It's important to remember that in qualifying for student loans backed by the federal government, the lender will not count IRA accounts as an asset, whether it's the student or parent who holds the IRA. Pre-tax contributions to a traditional IRA as well as distributions, however, are counted as income no matter who owns the account. If you are applying for a student loan, and your parent is making regular withdrawals from an IRA, the lender will consider that income as available to pay for student expenses.

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