PFwise.com
Search
  • Home
  • Blog
  • Tools
  • Know-how
    • Insurance 101
    • Annuity 101
    • College Planning
    • Real Estate
    • Retirement Planning
    • Smart Investment
    • Stock Ideas
    • Tax Planning
  • About Us
  • 中文
  • Resources
    • Personal Finance Reading List
    • Financial Aid Resources
    • Personal Finance Calendar
    • Retirement Planning Calendar
    • ETF list
    • Financial Glossary
  • Newsletters Archive

What is the Best Way to Save for College - Traditional IRA

5/23/2014

0 Comments

 
This is part of the Best Ways to Save for College series. We all know Traditional IRA is a type of retirement account, but this blog post will focus on how it's related to saving for college.

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?
No.

What Are the Tax Treatments?
Contributions

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
or
    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.

Growth

Tax-deferred.

Withdrawals

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).


Caution
As you can see, this could be a very complicated issue, please make sure consult your tax accountant before you take any action!
0 Comments



Leave a Reply.

    Author

    PFwise's goal is to help ordinary people make wise personal finance decisions.

    Archives

    April 2022
    March 2022
    February 2022
    January 2022
    December 2021
    November 2021
    October 2021
    September 2021
    August 2021
    July 2021
    June 2021
    May 2021
    April 2021
    March 2021
    February 2021
    January 2021
    December 2020
    November 2020
    October 2020
    September 2020
    August 2020
    July 2020
    June 2020
    May 2020
    April 2020
    March 2020
    February 2020
    January 2020
    December 2019
    November 2019
    October 2019
    September 2019
    August 2019
    July 2019
    June 2019
    May 2019
    April 2019
    March 2019
    February 2019
    January 2019
    December 2018
    November 2018
    October 2018
    September 2018
    August 2018
    July 2018
    June 2018
    May 2018
    April 2018
    March 2018
    February 2018
    January 2018
    December 2017
    November 2017
    October 2017
    September 2017
    August 2017
    July 2017
    June 2017
    May 2017
    April 2017
    March 2017
    February 2017
    January 2017
    December 2016
    November 2016
    October 2016
    September 2016
    August 2016
    July 2016
    June 2016
    May 2016
    April 2016
    March 2016
    February 2016
    January 2016
    December 2015
    November 2015
    October 2015
    September 2015
    August 2015
    July 2015
    June 2015
    May 2015
    April 2015
    March 2015
    February 2015
    January 2015
    December 2014
    November 2014
    October 2014
    September 2014
    August 2014
    July 2014
    June 2014
    May 2014
    April 2014
    March 2014
    February 2014
    January 2014
    December 2013
    November 2013
    October 2013
    September 2013
    August 2013
    July 2013
    June 2013
    May 2013

    Categories

    All
    Annuity
    Book Reviews
    College Finance
    Finance In Formula
    Financial Scams
    For Entrepreneurs
    Healthcare
    Insurance
    Investment
    Miscellaneous
    Real Estate
    Retirement
    Savings
    Savings Ideas
    Stock-ideas
    Tax
    Tax-related

    RSS Feed

Copyright © 2013 - 2022 PFWise.com, All Rights Reserved. 
IMPORTANT DISCLOSURES
PFwise.com does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances.

To the extent that any material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
About Us | Contact Us 
中文