Potential Advantages:
Perhaps the biggest potential advantage to using an IRA is that retirement plan assets are not included in most financial aid calculations. If an identical amount of money is saved in a Coverdell ESA or Section 529 account, 5.64% of its value will count against financial aid each year.Another advantage is that unused funds, if held in the IRA until normal retirement age (at least 59 1/2), will not be subject to a 10% withdrawal penalty. In the case of a Roth IRA, they will not be subject to income tax, either.
This stands in contrast to the 10% penalty (plus incomes taxes) levied against unused Section 529 or Coverdell ESA funds when they are withdrawn.
Potential Disadvantages:
There are numerous disadvantages to this strategy as well. Perhaps the biggest is the loss of the use of an IRA for your annual retirement savings. Using a retirement IRA to save for college costs you the opportunity to use it to save for your future. Since retirement will be much more costly than a college education, this is a key consideration.Another disadvantage will be the taxation on withdrawn funds. In a Traditional (deductible) IRA, the entire withdrawn amount will be subject to Federal and state income tax. In a Roth IRA, any funds withdrawn above and beyond your original contributions will be taxed at a Federal and state level.
When this is compared against the tax-free withdrawals permitted for Section 529 plans and Coverdell ESA’s, this can represent a significant waste of money.
For example, a $20,000 taxable withdrawal for qualified expenses from either type of IRA might easily cost $5,000 in taxes (assuming a 25% Federal and 5% state tax rate). This same withdrawal from a Section 529 or Coverdell ESA account would be tax free.
