Taking Early Distributions For Higher Education

Avoiding the 10% Penalty Tax for Early Withdrawals from IRAs

Apr 17, 2009

Taking an early distribution from IRA is one way of funding for a child's higher education. Higher education expense is one of the qualified early distributions allowed.

With tuition costs going through the roof, funding the college education of their offspring can be a real challenge for many parents. While there are plans specifically meant to save for higher education, like Coverdell accounts and 529 plans, sometimes digging into the retirement account may be the only option available for some parents.

Taking an early distribution from the retirement account can never be encouraged, but it is often unavoidable. Generally an early distribution (distribution taken before the account holder reaches 591/2) forces the account holder to pay a 10% penalty on the distribution amount, but this can be avoided if the distribution is taken to pay for higher education expenses. Keep in mind that although the 10% penalty can be avoided, the account holder may still have to pay income tax on all or at least a part of the amount distributed.

The distribution can be taken to pay for the education expenses of the account holder, his/her spouse, account holder's/spouse's children, foster children, grandchildren and any of their descendants.

Qualified Education Expenses

Qualified education expenses as defined by IRS are tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. In the case of special needs students this also includes expenses for special needs services incurred by them. The cost of room and board, as defined by the educational institution or the actual cost of boarding incurred by the student if he is residing in housing provided by the educational institution, are also included as qualified expenses if the student is at least a part-time student.

If the distribution amount is equal to or less than the adjusted qualified education expenses, then the early distribution is not subject to the 10% penalty.

Adjusted Qualified Education Expense

The adjusted qualified education expense is calculated by reducing the amount of any tax free educational assistance that the student receives from the total qualified educational expenses. The tax free educational assistance includes the following - tax-free distributions from a Coverdell education savings account, the tax-free part of scholarships and fellowships, Pell grants, Veterans' educational assistance, employer-provided educational assistance and any other tax free assistance excluding gifts and inheritances.

For example if a student receives a tax-free scholarship(without any other tax-free assistance), the qualified education expenses can be calculated by reducing the scholarship amount from the total of qualified education expenses.

Eligible Educational Institution

Any college, university, vocational school, or other post-secondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education is considered an eligible educational institution. Contact the educational institution to know whether it is an eligible institution. Saving and providing for a child's education is the biggest investment that can be made any parent. A higher education almost always paves the way for a higher standard of living and better quality of living.

Sometimes it is advantageous to save for college education with an IRA instead of keeping a separate education account, particularly if the parent is not sure that the child will use the funds for his/her education. Funds in an education account if not used for education purposes will incur a penalty. If a child does not go to college or gets a scholarship for higher education, the parent will lose the tax benefits of saving in an education account.

Keeping the funds in a retirement account ensures that even if the amount is not used for education, it can be still be used for retirement. One important point to consider in this case is that the total amount that is saved for retirement and education should be within the contribution limits of an IRA. Otherwise he would end up saving less for both college and retirement because of the contribution limits.

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