Thursday, August 21, 1997

Using IRAs for college gets low grades

By KAREN DAMATO / The Wall Street Journal

The new tax law makes it easier to pull money out of individual retirement accounts to pay kids' college bills. But most parents should try to avoid draining their IRAs that way, financial advisers and others say.

While the added flexibility is desirable, a retirement account "is the last place I'd go" to scrounge up cash for college, says Lynn Hopewell, a financial adviser in Fairfax, Va.

For people paying college expenses, the law waives the 10 percent penalty tax that usually applies when money is withdrawn from IRAs before age 59.5. That easier access may encourage more young people to put money into IRAs marketed by mutual-fund companies and other providers.

The law also creates attractive "education IRAs," that aren't really retirement accounts at all.

The new education IRAs are specifically designed to pay college bills. However, advisers say pulling money out of retirement-oriented IRAs to pay tuition, now becoming easier, isn't the best use of these investment vehicles. Money growing in those accounts enjoys special tax privileges that magnify with time. Mr. Hopewell's advice: "Keep your privileged status for as long as you can."

There has been considerable confusion over the past few weeks about the changing rules on money withdrawn from IRAs to pay college bills. It's clear that there is sweet tax treatment for the education IRAs, which will appear next year and to which contributions are, unfortunately, limited to $500 per child per year. While those contributions aren't tax deductible, money withdrawn from those accounts to pay for qualifying higher-education expenses will completely escape federal tax.

Some tax and mutual-fund professionals initially believed that same tax-free treatment would be available to sums withdrawn from the new retirement-oriented Roth IRAs - named for Senate Finance Committee Chairman William V. Roth Jr. - and used to pay for education. But that will generally not be the case.

Money can be withdrawn from a Roth IRA tax-free if the account has been open for at least five years and the holder is at least 59.5 (or is disabled or has died). First-time home buyers can also pull out as much as $10,000 tax-free. By contrast, a person who closes a Roth IRA early to pay college bills will avoid tax penalties but will owe tax on the accumulated earnings at ordinary income-tax rates.

A few exceptions: Older parents who are beyond the age 59.5 threshold when they write those tuition checks get their money out tax-free. And no tax is due for any Roth IRA-holder who withdraws an amount less than the original contribution. That's because withdrawals are considered to come from contributions and then from earnings.

When the Roth IRA appears next year, people at some income levels will qualify to put money into either the Roth IRA (to which contributions aren't tax deductible) or a traditional tax-deductible IRA. Those who think they may need to pull the money out for kids' college bills would probably do better to pick the deductible IRA, according to an analysis by fund company T. Rowe Price Associates, Baltimore. That account is likely to give them more money - provided, that is, that the annual tax savings are invested and added to the college kitty. A Roth IRA, by contrast, could end up generating less money for college than a taxable account that had most of its earnings taxed as long-term capital gains.

But clearly neither IRA is an ideal college-savings vehicle. In pulling earnings out of a Roth IRA before age 59.5, "you are paying tax on something that would have been tax-free" later on, says Bernard Kent, a Detroit tax partner with accountants Coopers & Lybrand. Not an attractive proposition.

In using a deductible IRA to accumulate college savings, meanwhile, the taxpayer gets a tax deduction upfront but then owes tax at ordinary income rates on every dollar that comes out. Deferring tax like that can produce some savings over a relatively short holding period of, say, 10 years. When money is left untaxed for decades, though, Mr. Kent says, tax deferral "really is the eighth wonder of the world."

Rather than pulling money out of IRAs to pay college bills, some parents may want to borrow money from their company 401(k) or profit-sharing plans, suggests Michael McCarthy, a financial planner with consultants Hewitt Associates in Lincolnshire, Ill. By taking a loan and repaying it, he notes, "you can preserve tax deferral for another 20, 25 or 30 years."

Even though taking money out of IRAs for college bills isn't a great idea, some tax and fund specialists believe having that option will be a big plus in luring contributions. "A lot of people won't go into retirement accounts because they are afraid they are going to need the money," says Joan Vines, national director of employee-benefits tax services for accountants Grant Thornton. The expanded access, she says, "removes the fear factor."