Understanding 401(k) and IRA Withdrawals for Education Expenses

A student’s education expenses may be reduced when a parent uses their tax-advantaged retirement account to help cover tuition and other related costs. With many students graduating with college loan debt, using a 401(k) or IRA may help lessen the burden of paying off education-related debt. However, before deciding to withdraw from a 401(k) or an IRA, knowing the rules and how they may impact you is essential.

Usually, if one withdraws money from a 401(k) or IRA before age 59 1/2, they will pay a 10% penalty and taxes on the withdrawal. But, the 10% penalty does not apply to 401(k)s and IRA withdrawals when used for ‘qualified’ education expenses. The IRS views qualified education expenses as the amounts paid for tuition, fees, and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution. Qualified expenses include:

• Tuition and enrollment fees
• Books and equipment
• Student activity fees

These expenses are not considered qualified expenses:

• Room and board
• Insurance
• Medical expenses (including student health fees)
• Transportation
• Similar personal, living, or family expenses
• Sports, games, hobbies, non-credit courses

Here’s what you need to know when using your 401(k) or IRA for education expenses:

401(k) withdrawals- If your employer’s 401(k) plan allows for withdrawals for education expenses, you can withdraw from your 401(k) and avoid the IRS’ 10% early withdrawal penalty. You may also take a loan from your 401(k) plan; visit with your plan administrator or human resources department to understand how the rules may impact you.

If you take a loan, you may be able to take a tax credit when you file taxes for the year you paid the expenses; however, not in the year, you get the loan or the year you repay the loan. Because this may need clarification, consult your tax professional before taking a 401(k) loan.

Remember that penalty-free does not mean tax-free. Since contributions to a 401(k) are made pre-tax, taxes will be due on the amount you withdraw for education expenses. It’s essential to keep records of each education expense for tax filing purposes.

401(k) Roth IRA withdrawals- The same rules as 401(k) withdrawals apply to a Roth 401(k), but only if the employer’s plan permits withdrawals for qualified education expenses.

IRA withdrawals- IRA withdrawals are IRS 10% penalty-free if used to pay for qualified education expenses, regardless of the account owner’s age. However, taxes will be due on the withdrawal amount in the year taken.

Roth IRA withdrawals- Contributions to a Roth IRA can be taken out penalty-free for qualified education expenses at any time after the account has been open for at least five years, even if the account owner is under age 59 1/2. Since Roth IRA contributions are made with after-tax dollars, no taxes are due on the withdrawal.

Investing in education for your child is an investment that pays off over time. Suppose you are considering a 401(k) or IRA withdrawal to help pay college expenses for your child. In that case, your financial professional can help you understand how taxes and early withdrawal penalties may impact your situation.

Important Disclosures:

Content in this material is for educational and general information only and not intended to provide specific advice or recommendations for any individual.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

This article was prepared by Fresh Finance.

LPL Tracking #1-05372941

Sources:

https://www.irs.gov/credits-deductions/individuals/qualified-ed-expenses#:~:text=Qualified%20expenses%20are%20amounts%20paid,at%20an%20eligible%20educational%20institution.

https://www.bankrate.com/retirement/ways-to-take-penalty-free-withdrawals-from-ira-or-401k/