Retirement funds may help your pay for college expenses. You can withdraw funds from your IRA without penalty to pay qualified higher education expenses.

Normally, if you withdraw money from a traditional or Roth IRA before you reach age 59½, you would pay a 10% early distribution penalty on the distribution, in addition to any regular income tax due. There is, however, an exception for distributions used to pay qualified higher education expenses. The portion of the distribution used for qualified higher education expenses is exempt from the 10% early distribution penalty. You will still pay income tax on the portion of the distribution that would otherwise have been subject to income tax. The qualified higher education expenses must be for you, your spouse, your children or your grandchildren. Qualified higher education expenses include tuition, fees, books, supplies and equipment, as well as room and board if the student is enrolled at least half time in a degree program.

With a traditional IRA, the full amount of the distribution is still subject to income tax. With a Roth IRA, the portion of the distribution that comes from your contributions is tax-free, but the portion that comes from earnings is still subject to income tax if withdrawn before you reach age 59½. (If you've reached age 59½ and have held the Roth IRA for at least five years, the entire distribution is tax free.) If you limit your withdrawals from a Roth IRA to just the contributions, the entire withdrawal is tax-free. Using a traditional IRA or Roth IRA for qualified higher education expenses just gets rid of the 10% early withdrawal penalty.

The advantages of the elimination of the early withdrawal penalty are as follows:

• This effectively turns a traditional IRA into a tax-deferred college savings vehicle.
• If you limit your withdrawals from a Roth IRA to just the contributions, the distribution is tax and penalty free when used for qualified higher education expenses.
• Funds in a traditional IRA are sheltered from the financial aid need analysis, and so have no impact on financial aid eligibility.
• Asset control remains with the parent.
• There is no income phaseout.

The disadvantages of using penalty-free withdrawals from individual retirement plans are as follows:

• Although the amounts in a traditional IRA are sheltered from need-based financial aid, the amounts withdrawn may count as income and affect eligibility for need-based financial aid during the next year. (If the distribution is tax-free, it counts as untaxed income and still impacts the need analysis process.)
• The current year contributions to a traditional IRA are counted as untaxed income, even though the amounts already in the IRA are ignored.
• The distribution must occur during the same year in which the qualified expenses are paid, so you cannot withdraw the funds a year before or a year afterward.
• Contributions to an IRA are $4,000 2007 and $5000 in 2008, and will be adjusted for inflation in subsequent years. There are also catch-up provisions if you are age 50 or older, allowing for an additional $1,000 beginning in 2006.
• You are using up your retirement savings. Once the money has been withdrawn from the IRA, you can't put it back. The only way to increase your IRA balance is through the normal contributions, which are subject to the annual limits.
• Qualified education expenses can be used to justify only one education tax benefit. You can't double-dip. If you use them to justify a penalty-free withdrawal from your individual retirement account, you can't use the same expenses to justify a Hope Scholarship or Lifetime Learning tax credit.

In most cases you will be better off using a section 529 plan for your college savings. Penalty-free withdrawals from retirement funds are mainly useful when you didn't plan ahead and need to tap your retirement savings to pay for college expenses. A Roth IRA might also be a useful college savings vehicle for grandparents, who start saving at least five years before turning age 59½, and won't otherwise need the funds for their own retirement. But generally speaking, withdrawing money from your retirement plan should be considered only as a last resort.