Dear Carrie: Can I borrow from an IRA account to pay for my daughter's college education? What are the parameters and pitfalls?
-- A Reader
Dear Reader: Your question combines two of the issues I'm asked about most often: paying for college and planning for retirement. These are pressing needs for most Americans, and they are often competing ones.
I have a "bad news/good news" answer for you. The "bad" news is that you cannot "borrow" from your IRA for any reason. The "good" news is that you cannot borrow from your IRA for any reason -- and it's good because it helps you preserve what is probably the cornerstone of your own retirement plan.
IRA "HARDSHIP" DISTRIBUTION
Many company-sponsored 401(k) plans do permit plan participants to borrow from their accounts -- to borrow from themselves, in other words. IRAs don't offer that feature. But like a 401(k), you can make what the Internal Revenue Service calls a "hardship distribution" from your IRA.
Here's how it works. Typically, if you withdraw money from your IRA or 401(k) before you turn 59 1/2, you'll have to pay a 10 percent early withdrawal penalty in addition to income tax. But in some instances, your withdrawal can be considered a hardship distribution, and the IRS will waive the 10 percent penalty.
For example, if you want to take money out of your IRA to cover medical expenses above a certain percentage of your income, or for a down payment on a first-time home purchase (up to $10,000), or to pay for higher education expenses, the IRS allows you to do so penalty-free. (Note that higher education expenses do not qualify as hardship withdrawals from a 401(k).)
But even without the penalty, taking money out of your IRA can be an expensive proposition. You're still on the hook for income taxes, and you're giving up some of your opportunity to build wealth for your retirement.
Let's say you are 50 years old, in the 28 percent tax bracket, and you need $10,000 for your daughter's college expenses this year. If you withdraw that amount from your IRA, you'll pay $2,800 for federal income taxes and possibly state income taxes on top of that. But that doesn't reflect the true cost of your withdrawal.
You have to factor in the opportunity costs -- the potential investment income your distribution might have generated. For example, let's assume that your $10,000 withdrawal could have earned a conservative 6 percent for the next 15 years until you retire at age 65. You'd be giving up around $14,000 in potential investment income. Put another away, your $10,000 withdrawal would generate only $7,200 cash in hand; if left alone in your IRA, it could reasonably become nearly $24,000 in 15 years. That's quite a difference!
Your daughter can apply for financial aid, which many schools are prepared to give. Aid might include scholarships or loans, or a combination of both. No one likes to start out in life with a mountain of debt, but I believe student loans are an investment in the future. A college degree should increase your daughter's earning potential over the course of her adult life. Of course, you could also consider borrowing from a home equity line, if you have a reasonable amount of equity in your home, but only if you are confident that you can repay the loan without undue hardship.
Finally, there are ways to make higher education more affordable. Some people go to inexpensive junior colleges for a year or two before transferring to a bigger name (and probably more expensive) school to earn their degree. Some go part time while working to help defray expenses.
It's certainly commendable that you're eager to help your daughter pay for college -- but I think it's pretty clear that you should think of your IRA as a last resort. As a general rule, it's more important for most people to fund their retirements than it is to fund their children's higher education. That's because your children have alternative ways to pay for college, but unless you have a pension or expect to inherit a lot of money before you retire, you don't have many alternatives for financing your later years.
And you surely don't want to be a financial burden on your children when you're older, so keep your money in the IRA and look for other ways to get your daughter through school. Good luck!
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Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER (tm) is president of the Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at firstname.lastname@example.org. This column is no substitute for an individualized recommendation, tax or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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