If you are older than 59½ and have been contributing to your IRA for more than five years, you may withdraw funds to pay off your student loans at any time. If you are younger than 59½, you can still use your IRA funds to pay for college loans, but your withdrawals are likely to be subject to tax penalties.
To discourage the use of IRA savings prior to retirement, the IRS imposes a 10% tax penalty on any withdrawals of taxable funds made before the account owner has reached age 59½. This penalty is intended to deter those who have other means of generating income, so this restriction does not apply if you are totally and permanently disabled.
This penalty is in addition to any income tax that you may owe on funds distributed from your IRA. If your normal income tax rate is 22% and you withdraw $10,000 in taxable funds from your IRA to pay off loans prior to reaching retirement age, your effective tax rate for this distribution is 32%. Of the $10,000 you withdraw, you will owe $3,200 in taxes.
In general, any early withdrawal from a traditional IRA is subject to taxation and penalty, unless you have contributed after-tax dollars. Even if part of your balance is comprised of these non-deductible contributions, however, distributions from traditional IRAs are not made in any particular order, so at least a portion of your withdrawal is taxable.
In contrast, withdrawal of funds from a Roth IRA are more likely to be tax-free and penalty-free, whatever your age, since you paid income tax on those dollars in the year they were earned and contributed. Because contributions to Roth accounts are always made with after-tax dollars, a person can withdraw his or her direct contributions whenever he or she likes, in whatever amounts, and for whatever purpose. Only that portion of an early withdrawal that comes from earnings is subject to taxation and penalty.
Contributions to Roth IRAs are always distributed before earnings. Therefore, if the amount of your student loans is less than or equal to the amount of your contributions to a Roth IRA, you can use those funds to pay off your loans without incurring the additional penalty or paying income tax, even before you reach retirement age.
Regardless of whether you have a traditional or Roth IRA, there is one penalty-free way to use your retirement savings to pay for your education. IRA withdrawals that are used for qualified education expenses at an eligible institution are exempt from the penalty. While the amount of your withdrawal cannot exceed your total education costs for the current year, you can use IRA funds to cover a wide range of expenses. Qualified expenses include tuition, books, room and board, fees, equipment and supplies, and special needs services. (Repaying student loans is not a qualified education expense.)
Though the 10% tax penalty is waived, you still owe income tax on any taxable amount of your distribution from a traditional IRA. Distributions from Roth IRAs, whether from contributions or earnings, are completely tax- and penalty-free in this case.
This exception applies to educational expenses for you, your spouse, your children or your grandchildren. Though this may not be a viable option for college-aged students who have not yet accrued substantial retirement savings, those who pursue higher education later in life can benefit greatly. For related reading, see Can my IRA be used for college tuition?