Saving for college is rarely a simple endeavor. While clients have many tax-preferred options, most require significant advance planning. When the bulk of a client's assets is tied up in retirement savings or when costs exceed amounts earmarked for education costs, college saving can become even more complicated. Fortunately, if the client owns an IRA, they aren't without options.
While penalties on early withdrawals are imposed to prevent clients from raiding their retirement savings for any reason whatsoever, there are important exceptions.
If the client follows the rules, they may be entitled to access IRA funds without penalty to cover the cost of higher education. However, it's important to pay attention to the specific rules imposed by the IRA before taking advantage of this option.
Higher Education Penalty Exception: The Basics
Taxpayers who have yet to reach age 59.5 may be able to tap their IRA savings without penalty to cover the costs of higher education. This penalty-free withdrawal option is only available only to IRA owners (not participants in company-sponsored plans, such as 401(k)s).
The taxpayer can withdraw funds to cover the cost of higher education expenses for themselves, their spouse, children or grandchildren (other relatives do not qualify). While these funds are subject to ordinary income tax in the year of distribution, the otherwise-applicable 10% early withdrawal penalty does not apply if the student is enrolled at an eligible education institution (colleges and universities but not high schools). It's important to verify that the institution is "eligible" before taking the distribution.
There is no limit to the amount that can be withdrawn to cover qualifying expenses. The distribution, however, must be taken in the year the qualifying education bill is paid.
Qualifying education expenses include tuition, fees, books, supplies and computer equipment used by the student, even if the equipment is not specifically required by the college or university. If the student is enrolled at the institution at least half time, room and board expenses also qualify.
It's important for the client to pay close attention to their Form 1099-R, which will list the distribution as an "early" withdrawal but will not provide information about the exception that applies. The client must report that exception themselves when filing their taxes for the year of distribution to avoid the penalty.
