What is Traditional IRA?
Traditional IRA is a retirement savings plan that allows income earners to defer taxation on earned income, dividends, interest, and capital gains until retirement. It should be noted that IRAs are not specifically education savings accounts.
Who Are the Owners/Beneficiaries?
The person who establishes the Traditional IRA account is the owner, and the owner controls the Traditional IRA for all purposes at all time.
For IRAs, there is no designated beneficiary related to education withdrawals. An IRA beneficiary simply inherits the account upon the owner’s death.
How Traditional IRA Could Be Used for College Fund?
When the Traditional IRA account owner is 59½, withdrawals may be used for any purpose. For owners under 59½, a 10% penalty on earnings withdrawals applies, but is eliminated when the withdrawal is used to pay for qualified education expenses for the account owner, their spouse, or their child or grandchild.
Qualified education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Room and Board costs, with certain restrictions, are qualified education expenses for students enrolled at least half-time.
What Happens if Fund Not Used for Education?
Since the traditional IRA is not specifically designed for college savings, there are no specific penalties related to the use of the funds for non-education costs. In general, if the account owner uses the funds before they turn 59½, they will be subject to a 10% early withdrawal penalty on earnings, unless they meet one of criteria for exemptions to the penalty.
What Are the Contribution Limits?
Annual: An individual may make a contribution of the smaller of $5,500 (2014) or their total earned income. Individuals 50 years old and older may make an additional “catch-up contribution” of $1,000 as long as the total contribution does not exceed their total earned income. The contribution limit is indexed to inflation and should increase over time.
Spouses of wage earners may make contributions to IRAs based on their spouse’s income. Note: these limits apply to the sum of contributions to Roth and Traditional IRAs. See IRS Publication 590. Contributions for year 2014 may be made until April 15, 2015.
Lifetime: Contributions must stop in the year in which the contributor becomes 70½.
What Are the Investment Choices?
A contributor chooses the investment vehicle depending on plan’s sponsor.
Can Traditional IRA Be Transferred?
What Are the Tax Treatments?
Contributions are deductible on federal tax returns under two specific and very limited circumstances:
1. The income earner is not eligible to participate in an employer sponsored retirement plan and is either unmarried or has a non-working spouse
2. The contributor’s household income (defined as modified Adjusted Gross Income) is below certain IRS defined limits. (This is a very complicated issue, Please see IRS Publication 590 before concluding you may deduct your traditional IRA contribution.)
If the contributor does not meet one of these criteria, the contribution is non-deductible.
NOTE: The rules for deduction an IRA for a non-working spouse with a working spouse covered by an employer sponsored retirement plan are too complicated for this discussion, please refer to IRS Publication 590.
For account owners older than 59½, withdrawals for any purpose are subject to income tax (except for withdrawals of contributions that were not deducted when the contribution was made). For those younger than 59½, the earnings are subject to income tax and a 10% early withdrawal penalty. The penalty does not apply if the funds are used to pay qualifying education expenses for the taxpayer, the taxpayer’s spouse, or the taxpayer’s child or grandchild. The “Ordering Rules for Distributions” that are described in the Roth IRA section of this document do not apply to Traditional IRA withdrawals.
What Are the Other Important Notes?
The taxable amount of a withdrawal from a Traditional IRA is taxed at the owner’s income tax rate, which is typically higher than the capital gains rate. As a consequence, Traditional IRAs may not provide more after tax value than even direct investments (use this free tool to check it out).
For those whose goal it is to maximize their after-tax savings for education purposes, there may be better options. However, since many people already have traditional IRAs, either from contributions or rollovers from employer retirement plans, it is useful to remember the penalty exemption for qualified education expenses.
Conversion to Roth IRA
Starting in 2010, anyone who owns a Traditional IRA (or a SEP IRA, SIMPLE IRA, 401k, 403b, or 457 plan and is not employed by the company at which the plan is held) may convert that plan into a Roth IRA. The account owner will be taxed on the pre-taxed and deductible contributions and any earnings in the converted amount. Non-deductible contributions are not subject to taxation during the conversion.
Example 1: Jill is a single taxpayer whose income is $150,000: she is not able to contribute directly to a Roth IRA. However, she has $50,000 in a Traditional IRA that she created when she left her former employer and rolled her 401k into the IRA. All of the contributions in the 401k were made with pre-tax dollars. Jill can convert all or part of this Traditional IRA into a Roth IRA. She’ll have to pay income tax on the entire amount converted.
People who do not have a Traditional IRA can create Roth IRA to avoid future tax liability. They can deposit funds (subject to the annual contribution limits) into a Traditional IRA and immediately convert the Traditional IRA into a Roth IRA. Assuming this is done on the day of the deposit, and there has been no time for earning to accrue, this should be a tax free process. This can be repeated annually to grow the account.
Taxpayers who have traditional IRAs funded from rollovers from employer sponsored retirement plans, or from past deductible contributions, or with a lot of earnings, should review the conversion rules in IRS Publication 590. These accounts cannot be segregated from the newer contributions and will cause the taxpayer doing a conversion from a traditional to a Roth IRA to pay more taxes than expected.
Example 2: Jack is single taxpayer whose income is $150,000: he is not able to contribute directly to a Roth IRA. However, he has $55,000 in a Traditional IRA that he created when he left his former employer and rolled his 401k into the IRA. All of the contributions in the 401k were made with pre-tax dollars.
Jack contributes $5,500 to a Traditional IRA at a different company from the one that holds his current IRA, with after tax dollars (a non-deductible contribution) and immediately converts this new $5,500 into a Roth IRA. He thinks he has no tax liability, but he is incorrect. Even though he segregated the new, non-deductible contribution from the older account, the IRS considers all Traditional IRAs one account. Jack is required to determine the ratio of pre-taxed assets to total assets in all of his Traditional IRAs (in this example, 10/11ths of his Traditional IRAs have not been taxed), and must report a proportional amount of the converted amount on his income tax return (10/11ths of $5,500 is $5,000: Zach must report $5,000 on his income tax return as taxable income).
As you can see, this could be a very complicated issue, please make sure consult your tax accountant before you take any action!