Q. My parents came into some money and want to help with my children’s college costs and our retirement. Someone suggested they fund Roth IRAs for all of us. The boys are both working part time and have earned income. I think this may make sense but I’m worried about the five-year rule for withdrawals from Roth IRAs. My husband and I funded Roth IRAs of our own last year and my parents plan to add to these. Can we use these for college once we are 59 1/2 even if they haven’t been open for five years? We married and had kids later in life and will be 59 1/2 when our 18-year-old begins his sophomore year of college. In short, could you explain the details of the five-year rule concerning Roth IRAs?
A. There are several ways for your parents to help with college funding. If you think your sons may qualify for financial aid, be careful that any help won’t interfere with this. Any money gifted directly to your sons could interfere with financial aid eligibility. Retirement account funds are not counted as assets to be used for college when determining financial aid eligibility but any distributions made by your sons would count as income. Some colleges use their own calculations rather than the Free Application for Federal Student Aid (FAFSA) and a retirement asset may reduce the possibility of aid.
The five-year rule is often misunderstood when it comes to taxation and the 10 percent penalty on withdrawals of earnings from Roth IRAs. Withdrawals of contributions are always tax and penalty free. You can take out the exact amount of your contribution at any time for any reason without paying any tax or penalty.
Withdrawals of earnings are classified as either qualified or nonqualified. A qualified distribution of earnings from a Roth IRA is tax and penalty free provided that the five-year rule has been met and one of the following conditions are met: the owner is over age 59 1/2 , the owner dies or becomes disabled or the owner is a qualified first-time homebuyer. Up to $10,000 may be withdrawn without any tax or penalty for the purchase of a first home for the account holder, the account holder’s children or grandchildren. The five-year rule is met if the account has been open and funded for at least five years regardless of the age at which it was opened.
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A nonqualified distribution of earnings is subject to taxation and a 10 percent penalty unless an exception applies. One of the exceptions is paying for qualified higher education expenses for yourself or eligible family members. The Roth IRA would be a good investment vehicle for some of your parents’ monetary gifts. If you think your sons will qualify for financial aid, distributions from the Roth IRAs for the later years of college should not have much, if any, impact on the amount. If it turns out that none of the money in the Roth IRA is needed, it’s a nice start toward their retirement savings and a boost to yours.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, N.C. 27624