Early, penalty-free tapping of IRA for college

Question

Dear Joe, Is it true that you are able to use money from an IRA to pay for college costs without the penalty or having to repay? If so, is there a specific way to go about this? Are there forms to fill out, etc.? Or do you just take out the money? What documentation is needed? Any other information regarding this area would be extremely helpful. Thank you for your time and assistance. -- Angela

Answer

Dear Angela,

Yes, you can avoid the 10-percent tax penalty on early distributions from an IRA when you are paying qualified higher education expenses for yourself or for your spouse, child or grandchild. It's not necessary that the child or grandchild be your dependent. And unlike a 401(k) loan, you won't have the obligation -- or opportunity -- to repay your IRA.

The waiver applies to the penalty only and not to any tax owed on a traditional IRA distribution. (Of course, with a Roth IRA you can withdraw your regular contributions without tax or penalty at any time and for any purpose.) The optimal approach would be to leave any earnings accumulating in the Roth IRA until after you reach age 59½ and can withdraw them free from tax or penalty.

It is generally not a good idea to withdraw from an IRA if you or your child will be applying for federal financial aid in the following year. All IRA distributions, including taxed and untaxed portions, must be included in base-year income and will reduce aid eligibility. You may be much better off taking out an education loan and repaying the loan after the last financial aid application is filed.

To claim the penalty waiver, you must file Form 5329 with your Form 1040 and indicate the amount of qualifying higher education expenses incurred during the year. You don't have the use the IRA dollars directly to pay college expenses. For example, you will not owe the penalty if you pay $10,000 for qualifying expenses in January and withdraw $10,000 (or less) from your IRA in September of the same year. Refer to IRS Publication 970 for the specific categories of expenses that qualify for this exception and for the adjustment that must be made when you claim certain other education tax benefits. Keep documentation of your expenses so you can prove them to the IRS in the event of an examination.

And remember, raiding your IRA for college means it will not be there for you in retirement. Give some consideration to your other options for funding college.