Penalty-Free Withdrawals for Higher Education Expenses
The stores are filled with back-to-school supplies, and those with college-aged loved ones know that means get out the checkbook, college bills for the fall semester are arriving. You may need to consider where to take funds to cover the expenses, and taking money from your retirement funds could be considered. While it is not the ideal situation, sometimes, it makes sense to tap into them. IRA’s (including ROTH, SEP, and SIMPLE IRA’s) have some special rules that can allow, without dollar limitations, penalty-free withdrawals for those under age 59 ½. Knowing how to do it penalty-free can save you 10%.
Typically, IRA accounts are opened with the intent of saving for retirement. The IRS does allow some penalty-free exceptions for distributions taken outside of the typical intention. Higher education expenses happen to fall into that exception category. Of course, with any IRS regulation, it is not that cut and dry.
In the spirit of college education, I have prepared the cliff note version of what you need to know to take advantage of penalty-free IRA withdrawals for those under 59 ½, paying for higher education expenses.
Qualifying Education Expenses
Not every educational expense qualifies for IRS exemption. The student, school, and expense must meet the requirements to avoid a pre 59 ½ 10% penalty.
While 529 plans opened education expenses to include an elementary or secondary school,
the rule applied to penalty-free IRA withdrawals applies only to the costs paid to an accredited post-secondary educational institution. Therefore, it is your responsibility to verify that the school is eligible before requesting your distribution. The post-secondary school usually will qualify if it is eligible to patriciate in a student aid program administered by the US Department of Education.
Students must enroll at least half-time for eligibility. You will not avoid the penalty if you are only taking one of two classes per year.
The IRS qualifies expenses even further, and unfortunately, pizza isn’t on the list. Tuition, administrative fees, equipment, supplies, and books required by the school are all qualified. You can even cover expenses for computers and related equipment even if the school does not require it.
Not only can the IRA account owner have penalty fee distributions, but expenses paid for a spouse, child, stepchild, grandchild, or step-grandchild are all eligible. Sorry, your nephew Tommy isn’t included.
Keep in mind your distribution can’t exceed the amount of education expenses paid in the same calendar year. Furthermore, any fees paid for with tax-free educational assistance (scholarships, Pell grants, Coverdell accounts, and veterans aid) are not eligible for the 10% exception. For example, if annual tuition is $20,000 and your student received a $10,000 scholarship, qualifying tuition expenses will be $10,000.
Traditional vs. ROTH IRA
You can request distributions from your traditional or ROTH IRA for qualified distributions and avoid the 10% penalty if you are under 59 ½.
If you take funds from a traditional account, you will be required to include the proceeds as taxable income and taxed at your regular income tax rate. So, while the distribution is penalty-free, it is not income tax-free. Depending on your income level and distribution, the withdraw may put you in an even higher tax bracket.
Roth IRAs are treated differently since it’s funded with post-tax dollars. If your ROTH account has been opened for at least five years, you can withdraw your contributions both penalty and tax-free. Furthermore, if you are over 59 ½, the account is greater than five years old, there is no penalty or tax on both contributions and earnings.
IRS and Records
When you take a distribution from your IRA before age 59 ½, your custodian will send you a 1099-R showing and early distribution. The 1099 is prepared and distributed with your other tax documents during the first few months of the year after your distribution.
Unfortunately, your 1099 will not denote any exemption status. You must file form 5329 to claim your exemption using code “08” for education. The burden of proof for your exemption falls on you, so document the expenses you paid with the proceeds and keep those records on hand; you may need them in the event of a future audit.
Financial Aid and IRA Withdrawals
While these tips can help you avoid the early withdrawal penalties, distributions for ordinary retirement accounts will be treated as income and, therefore, can impact financial aid for the year following distributions. Depending on the amount, it could rule financial aid out entirely. Income from ROTH IRA earnings, not contributions, are also included as income. To avoid or limit impact, consider avoiding IRA distributions until the last year, or at least later years of college, to take advantage of the most financial aid possible.
Just in case you were wondering, paying student loans off after graduation does not meet the qualifying expense requirements, but I like the way you think.
Final Considerations
Again, the intent of IRA accounts is to fund retirement. Pre-mature IRA distributions could leave you underfunded for your golden years. While helping your kids with a solid education is an admirable goal, it doesn’t need to come at the expense of your retirement. Today, people have many opportunities to secure funding for higher education. Unfortunately, I am unaware of any institutions offering loans to fund retirement. Consider talking with a financial advisor to learn about your available options before taking early IRA distributions.
This material is provided as a courtesy and for educational purposes only. Investing involves risk including loss of principal. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. This article contains links to articles or other information that may be contained on a third-party website. River City Wealth Management is not responsible for and does not control, adopt, or endorse any content contained on any third-party website. The information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. Past performance is not indicative of future results.