Yes, You Can Pay for Education With an IRA

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When most people think of saving for a college education, they usually think of 529 savings plans or Coverdell Education Savings Accounts (ESA). These accounts allow you to grow your money by investing in select mutual funds, much like a typical retirement account does. (See also: 5 Smart Places to Stash Your Kid's College Savings)

While both of these accounts are great investment tools to pay for a college education, there's another option you may not have considered. A Roth IRA can also be used for educational expenses. There are pros and cons for each way to save for college. Here's a brief rundown:

Roth IRAs

A Roth IRA differs from a traditional IRA in that the income you contribute is already taxed. The beauty of a Roth IRA is that the distribution you take from your contributions is not taxable (as long as the use is approved).

Let's say your child is a college freshman. You withdraw $15,000 from your Roth IRA for their first year of school. None of this money will be taxed, as long as it is from your own contributions and not from the interest earned. Withdrawals are considered returns of contributions initially, for tax purposes. They are considered interest earnings second.

Now, you are likely thinking, "But aren't IRA withdrawals subject to penalties if you withdraw them early?" Generally, yes. Normally, you must be age 59 ½ or older, and have had the account for at least five years to withdraw without incurring a 10 percent tax penalty. Why? Well, all IRAs are retirement funds, primarily. They are designed to be withdrawn only as folks approach retirement.

But no penalty applies if the withdrawal is for qualified educational purposes (or a first home purchase, or qualified medical bills). Even if your child or grandchild has a scholarship for full tuition, it's no problem. Roth IRAs can be used for any qualified educational expense, including room, board, books, and supplies.

If your child or grandchild ends up not going to college, or not needing all the money, you can simply keep the money to continue funding your retirement. Note that to place money back into a Roth IRA, it will be subject to annual contribution limits ($5,500 if under age 50, and $6,500 if age 50 or older).

Traditional IRAs

You can also use traditional IRAs to pay for college. Essentially, traditional IRAs reverse the tax advantage of a Roth. You get a tax deduction upfront for all money contributed to a traditional IRA — but all withdrawals will be taxed at the federal and state level.

As with a Roth IRA, if traditional IRA distributions before age 59 ½ are used for qualified educational expenses, they are not subject to the 10 percent penalty. However, they will be subject to tax. The IRS will get its money whenever you withdraw from a traditional IRA, regardless of what you withdraw it for.

Because of the tax implications, while it is possible to use a traditional IRA for educational expenses, it may not be the most prudent move. If you want to tap into IRAs for college expenses, a Roth IRA is the better bet financially.

An important caveat

Realistically, tapping your IRA to pay for your child's education should rarely be your first choice. It can be a smart move if you have a considerable amount saved and a lot of time left before retirement to pay it back. Otherwise, you'll be draining the account of funds you very much need. It may be wiser to use an educational savings account to save for your child's education instead. (See also: Why Saving Too Much Money for a College Fund Is a Bad Idea)

However, there are still benefits of using an IRA over an educational savings account if you know your retirement will still be secure. For example, by combining the funds into one account, you will have more flexibility in choosing whether to spend your savings on education — and how much — or to continue to hold it for your retirement.

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