Penalty-free IRA withdrawals

IRA owners under age 59-1/2 can withdraw funds from their accounts penalty-free if the funds are used to pay "qualified higher education expenses" for the taxpayer, the taxpayer's spouse, or a child or grandchild of the taxpayer or the taxpayer's spouse. The taxpayer must include the distribution in income and pay income tax on it. The taxpayer avoids only the 10% early distribution penalty that would otherwise apply.

Qualified higher education expenses include not only tuition and fees but also books, supplies and equipment required for enrollment. They also include room and board if the student is enrolled at least half-time.

The waiver of the 10% penalty also applies to Roth IRA distributions that meet the above requirements. However, education distributions are not one of the special events entitling tax-free withdrawals of earnings from a Roth IRA.

Money Saving Tip. Grandparents, who are eligible to tap their IRAs to help their grandchildren pay for college, may want to pay the funds directly to the educational institution to avoid the annual gift tax exclusion limit ($13,000 in 2011).

The law strictly limits the timing of withdrawals to pay qualified expenses. The withdrawal from the IRA and the payment of qualified expenses must occur within the same calendar year. In one case, a taxpayer who took two distributions from her IRA in 2001 to pay down credit card debt incurred in 1999 and 2000 from paying qualified higher education expenses was not penalty free because the 2001 withdrawal related to 1999 and 2000 education payments. Lodder-Beckert, T.C. Memo. 2005-162. In another case, a 2002 IRA distribution was used to pay qualified expenses for 2003 and 2004 and, so, were not penalty free. Ambata, T.C. Summary Op. 2005-93.

The usual 60-day IRA rollover rule cannot be waived merely because funds are used to cover higher education costs. PLR 200504037. In this case, a parent took an IRA distribution because of problems processing his Free Application for Federal Student Aid (FAFSA) and things were not resolved within the 60-day rollover period.