The 10 percent penalty tax on withdrawals from an IRA before age 59-1/2 does not apply to distributions from either a traditional IRA or a Roth IRA to the extent that the amount withdrawn is used to pay qualified higher education expenses. The qualified higher education expenses may be incurred by the taxpayer, the taxpayer's spouse, or any child or grandchild of the taxpayer or the taxpayer's spouse.
Child means an individual who is a son, daughter, stepson or stepdaughter of the taxpayer, or an eligible foster child of the taxpayer (i.e., an individual who is placed with the taxpayer by an authorized placement agency, or by a judgment, decree or other order of a court of competent jurisdiction). A legally adopted child of the taxpayer, or a child who is placed with the taxpayer for legal adoption, is treated the same as a child by blood. A taxpayer is eligible to make a penalty-free withdrawal from an IRA to pay the qualified higher education expenses of a child even if the child is not a dependent of the taxpayer.
Example 1: Your client, who is 44, withdraws $10,000 from her traditional IRA to pay the qualified higher education expenses of her husband's 26-year-old son by a prior marriage. The son is not a dependent of the taxpayer, since he is over 24 years old. The withdrawal from the IRA will be penalty-free.
Caution: Even though the withdrawal is penalty-free, it will still be taxable income in the year withdrawn to the same extent that it would be taxable income if withdrawn after age 59-1/2. In the case of a traditional IRA, it would be taxable income to the extent that it was deemed made from deductible contributions and the earnings of the traditional IRA. In the case of a withdrawal from a Roth IRA, it would be taxable income only to the extent that it was deemed made out of the earnings of the Roth IRA.
However, if an exception to imposition of the penalty tax does not apply, a distribution from a Roth IRA can be subject to that penalty even if it is not includible in gross income, if it is allocable to a qualified rollover contribution from a traditional IRA, and it is made within the five-tax-year period beginning with the tax year in which the contribution was made.
Qualified expenses
The term "qualified higher education expenses" includes the following:
* Tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. An eligible institution includes accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, a graduate-level or professional degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions that are eligible to participate in Department of Education student aid programs also are eligible institutions. Thus, the term includes virtually all accredited public, nonprofit and proprietary (privately owned, profit-making) post-secondary institutions.
* In the case of a student carrying at least half the normal full-time work load for any academic period, the reasonable costs for the period incurred for room and board while attending the institution.
* In the case of a special needs beneficiary (i.e., an individual who, because of a physical, mental or emotional condition, including a learning disability, requires additional time to complete his education), expenses for special needs services that are incurred in connection with the enrollment or attendance of the beneficiary at the institution.
The total amount of qualified higher education expenses with respect to an individual for a tax year for purposes of calculating the qualified tuition program exclusion from income must be reduced by:
* Tax-free distributions from a Coverdell education savings account;
* The tax-free part of scholarships and fellowships;
* Pell grants;
* Tax-free employer-provided educational assistance;
* Veterans' educational assistance; and,
* Any other tax-free payment received as educational assistance.
Example 2: Your client's daughter's total qualified higher education expenses for 2005 are $40,000. Of this amount, $25,000 is paid through a combination of a tax-free scholarship, a tax-free distribution from a Coverdell ESA, and tax-free employer-provided educational assistance. The total amount that your client, who is 53, can withdraw from an IRA to pay her daughter's qualified higher education expenses without incurring the 10 percent penalty tax is $15,000 (total expenses of $40,000 less $25,000).
However, qualified higher education expenses paid with an individual's earnings, a loan, a gift, an inheritance given to the student or the individual claiming the credit, or personal savings (including savings from a qualified tuition program [also referred to as a 529 savings plan]) are included in determining the amount of the IRA withdrawal that is not subject to the 10 percent early withdrawal penalty tax.
Example 3: Your client's son's total of tuition, room and board, and other qualified higher education expenses at an accredited college in 2005 amount to $35,000. Your client pays $20,000 from a combination of earnings, loans and savings (including savings from a qualified tuition program). Her son pays $15,000 from a combination of gifts and inheritances.
None of these amounts reduce the amount ($35,000) that your client (who is 52) can withdraw from her IRA in 2005 without incurring the 10 percent penalty tax.
Note, however, that the amount treated as qualified higher education expenses is not the pre-tax amount that must be withdrawn to obtain sufficient after-tax dollars to pay a specified amount of otherwise qualified higher education expenses.
Example 4: Your client, who is 50, pays all of his daughter's $20,000 of qualified higher education expenses in 2005. He takes $30,000 (all of which is taxable income to him) out of his traditional IRA to pay the $20,000 plus $10,000 of federal and state income taxes on the total amount withdrawn. He can avoid the 10 percent penalty tax on the $20,000 used to pay the qualified higher education expenses, but not on the $10,000 used to pay income taxes on the total amount withdrawn.
All in the same year
The amount of a withdrawal from an IRA to pay qualified higher education expenses that is taken into account for purposes of avoiding the 10 percent penalty tax cannot be more than the amount of qualified higher education expenses paid for the tax year that the amount is withdrawn.
Thus, the amount withdrawn does not avoid the 10 percent penalty tax to the extent that it is used to pay amounts paid for qualified higher education expenses in earlier years, even if those expenses were paid by taking out a loan, and all or part of the amount withdrawn is used to pay off that loan.
Example 5: Your client, who is 49, borrowed $20,000 to pay the qualified higher education expenses of his son in 2004. He could have taken out the amount needed to pay those expenses from his traditional IRA, which was worth $150,000 at the end of 2004. However, his IRA was invested primarily in stocks that he expected to increase sharply in value by the middle of 2005. His expectation proved correct, and on July 15, 2005 (when the IRA was worth $250,000), he took out $40,000 from it, all of which was includible in his gross income.
Of this amount, $20,000 was used to pay qualified higher education expenses incurred for his son in 2005, and the remaining $20,000 was used to pay off the loan he took out to pay his son's qualified higher education expenses for 2004. He must pay the 10 percent penalty tax on the $20,000 taken out to pay off the loan used to pay his son's 2004 expenses.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
