Tapping an IRA to Pay Education Expenses? Avoid These 4 Mistakes
By Sarah Brenner, IRA Technical Expert
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Are you facing big college tuition bills? Generally, if you take a taxable distribution from your IRA before you reach age 59 ½, you will be subject to an additional 10% early distribution penalty. That is because your IRA is intended to be used for your retirement. However, an exception to the penalty allows you to take a penalty-free distribution from your IRA if you use the funds for qualified higher education expenses. Qualified higher education expenses include tuition, fees, books, and supplies. The expenses must be for education furnished to you, your spouse, or any child or grandchild of you or your spouse. The rules can be complicated and have confused many taxpayers looking to use retirement funds to pay for education. If you decide to tap your IRA early in order to pay for education costs, you will want to avoid these four mistakes that others have made.
- Wrong Tuition Bill. A father took a distribution from his IRA to pay his son’s tuition at a private high school. He argued that this qualified for the exception to the penalty. Both the IRS and the Tax Court disagreed. Only post-secondary expenses are considered qualified higher education expenses. Don’t make this father’s mistake. Your child’s high school or grade school tuition or expenses will not qualify.
- Not a “Required” Expense. Concerned parents purchased a computer for their daughter to use at college because they did not think it was safe for her to walk to the college’s computer lab after dark. The IRS and the Tax Court still said that the computer was not a qualified education expense and assessed the early distribution penalty. A qualified higher education expense must be a required expense and the daughter’s school did not require that students have a computer. If you purchase a computer for your child to use at college and this is not required, you will not be able to use the computer as a qualified education expense. (Editor's Note Update: Good news for parents looking to take penalty-free distributions from an IRA to buy a computer for a college student! As 2015 draws to a close, Congress just passed the PATH Act, which includes provisions expanding the definition of higher education expenses to include computers and related technology, even if not required by the school. Learn more here.)
- Bad Timing. A couple who took a distribution from an IRA in the year after paying a college tuition bill was hit with the 10% penalty despite their argument that they used the funds to guarantee their son’s student loan. The Tax Court said to qualify for the exception, the education expense and the IRA distribution must occur in the same year. Avoid this mistake. Be sure your IRA distribution and your education expense happen in the same tax year.
- Wrong Retirement Plan. A law student took a distribution from his Federal Thrift Savings Plan to pay his tuition. In court, he argued that the 10% penalty exception should apply even though the distribution came from a workplace plan and not an IRA. This argument was unsuccessful. Don’t make this mistake. The exception to the early distribution penalty for higher education only applies to distributions from your IRA, not distributions from your company plan.
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