With the cost of a college education rising faster than inflation, and at a higher rate than most are earning with their investments, many families are considering different options for trying to pay for tuition, room and board, and other higher education expenses for their children. Loans are an option, of course, but we’re seeing that many recent college graduates are having trouble handing tens (or even hundreds) of thousands of dollars of debt.
Some individuals are familiar with the various exceptions to the rules that prohibit early withdrawals from their IRAs. In particular, there is an exception that allows an IRA account holder to make withdrawals from their IRA without having to pay that 10% penalty in order to pay for certain qualified higher education expenses.
While this might sound like a good solution to the problem, it’s important to understand that there are some significant downsides to making an early withdrawal from your self-directed IRA to pay for your child’s college expenses.
You Lose Time Value Compounding. You probably know that the longer you have funds actively invested in your account, the greater chance you’re giving your account to grow. But when you take money out of your account when you’re still years (and maybe decades) away from retirement, you’re short-circuiting that growth. Withdraw $10,000 this year to pay for your child’s education, and that money could have been worth almost $50,000 in your account in 20 years (assuming an 8% rate of return). Now consider that the average yearly tuition at a private college in the U.S. is over $30,000 – and that $30,000 figure doesn’t include room and board.
You’ll Lose Investment Options. When you make early withdrawals from your self-directed IRA to pay for your child’s college expenses, you reduce the balance in your account. This provides you with fewer investment opportunities going forward. For example, because there are negative tax consequences to borrowing money within your self-directed IRA in order to purchase real estate, it’s usually preferable to try to purchase investment real estate in an all cash transaction. Having less money in your account means that you’ll have fewer options to make such an all cash purchase.
You Might Be Less Judicious in Your Spending. There are many IRA holders that have significant balances in their accounts. Unfortunately, this can sometimes lead to those individuals not fully appreciating just how costly it is to take out an additional $5,000 or $10,000 out of their account.
It’s obviously important that your child be able to get a quality education, but there are likely to be other ways that you can help them pay for it. You may wish to consider refinancing your mortgage or even downsizing your home, for example. It’s important to understand that the downsides of getting those funds from your self-directed IRA are significant.