Can Your Clients Tap an IRA to Pay for College?

Some taxpayers may be able to access their IRA savings to cover higher education costs without penalty.

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There is no limit to the amount that can be withdrawn to cover qualifying expenses.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.

Alternate Saving Strategies

Clients with more time to save may also wish to explore alternatives to accessing retirement savings prematurely. IRC Section 529 college savings plans are funded with after-tax dollars that are permitted to grow on a tax-free basis, so that distributions from the account are not taxed when received so long as they are used to pay for qualified higher education expenses.

Nonqualified distributions, which are distributions not used to pay for qualified education expenses, are included in gross income. However, only earnings on amounts that were contributed are taxed. So, while the after-tax funds that were originally contributed would not be subject to ordinary income tax a second time upon distribution, a 10% penalty does apply if the amounts are withdrawn to cover nonqualified expenses.

“Qualified education expenses” include tuition as well as fees, books, supplies and equipment that is required for the plan beneficiary’s enrollment at an eligible education institution, as well as reasonable expenses for room and board.

The student may use Section 529 plan funds and still qualify for education-related credits such as the American Opportunity or Lifetime Learning tax credits, so long as the same amounts are not used to cover the same qualified education expenses. Students are also required to reduce the total amount of their “qualified education expenses” by certain scholarships that they receive.

Contributions to a Section 529 plan are limited by the maximum lifetime limits of a plan and the annual gift tax exclusion amount. That means clients can contribute up to $17,000 per year in 2023 without a gift tax liability if no other contribution is made to the beneficiary. Section 529 plans also offer the chance to bundle contributions — allowing for a $85,000 contribution in one year rather than over a five-year period for gift tax purposes.

Conclusion

IRA funds can provide an important source of liquidity for clients who are struggling with the ever-rising cost of a college education. While alternative strategies may be available to avoid diminishing retirement savings returns, the penalty exception can provide a valuable option in the right situation.

(Pictured: Robert Bloink and William H. Byrnes)

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