With the cost of college rising, you may need to tap into your retirement savings to help your children make it through. While tapping your nest egg isn't ideal, tapping a rollover IRA for college costs offers a much better tax result than using certain other retirement plans because of the special early higher education withdrawal exception that applies to IRA distributions only.
Early Distribution Exception
The IRS grants an exemption from the 10 percent early withdrawal penalty for IRA distributions taken to pay for qualified higher education expenses for yourself as well as your spouse or your children. The exception applies to distributions from any IRA, including a rollover IRA, but not to other qualified plans, such as a 401(k) or 403(b). For example, if you take distribution from a 401(k) to pay for college for your son, you'll owe the early withdrawal penalty. However, if you first roll it into an IRA and then take the distribution, you avoid the penalty.
Most, but not all, costs paid during college qualify for the exception from the early withdrawal exception. Qualified costs include tuition, fees, books and other necessary supplies. If your son enrolls in at least enough credits to be considered a half-time student, room and board costs also qualify. "Half-time" is determined by each school. For example, if the college your son is attending requires 12 credits to be considered full-time, your son must enroll in at least six credits for room and board to be a qualified expense.
However, qualified expenses are reduced by any tax-free assistance your son receives. For example, if your son has $17,000 in qualified expenses but receives a $7,000 scholarship, the penalty exception only applies to up to $10,000 of expenses.
Taxes Still Apply
Just because Uncle Sam gave you a break on the early withdrawal penalty doesn't mean you're off the hook completely, because the higher education expenses exception doesn't apply to income taxes. The IRS taxes distributions as ordinary income. For example, if you fall in the 25 percent tax bracket and take a $5,000 rollover IRA distribution to pay for your son's college, you'll owe an extra $1,250 in taxes. However, any expenses you pay with distributions from a rollover IRA can count toward calculating an education tax credit, such as the lifetime learning credit or American opportunity credit.
When you do your taxes, you must account for the IRA distribution. First, report the distribution as a taxable IRA distribution on line 15b of Form 1040. Next, complete Form 5329 to report your exemption. Next to line 2, enter the code "08" which shows the IRS you used the money for qualified higher education costs. On line 2, report the amount of qualifying higher education expenses paid. As long you didn't withdraw more than the amount of qualifying higher education expenses, you won't owe any penalties.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."