Suppose you use your credit cards to pay for qualified education expenses. A few years later, with bills piling up and interest accumulating, you decide to dip into your IRA for an early distribution to pay off those expenses. Since the money's ultimately reimbursing your qualified education costs, can you avoid the usual tax penalty for tapping into your IRA before its time? Not according to a recent tax court case (Beckert v. Commissioner, T.C. Memo 2005-162 (7/5/05)).
Under Code Section 72(t), the IRS claims a 10% penalty on any early distribution from an IRA account. But subsection 2-E of that rule will spare you the extra tax hit if you use those IRA funds for qualified education expenses. The taxpayer in this case was hoping to use that exception, but made one key mistake. Here's a brief overview:
In 1999, Linda quit her job and asked to transfer her company retirement account balance into an IRA. She was told that pending legislation would greatly increase the balance of her retirement account if she kept the funds where they were. Linda left her employer but kept her retirement account intact, anticipating a future windfall.
In 1999 and 2000, Linda went back to school, amassing $12,063 in qualified education expenses. She paid with student loans and credit cards. In 2000, the promised legislation passed, nearly tripling Linda's retirement account balance. The following year, she had those funds transferred to an IRA.
Linda then took a $20,000 distribution from that IRA account. She used $12,063 of that distribution to pay off her past education expenses, including the credit card debt. The remaining $7,937 paid for qualified education expenses incurred in 2001.
When Linda prepared her 2001 tax return, she correctly claimed the $20,000 IRA distribution as taxable income. However, she didn't apply the 10% early-distribution penalty to any of it. The IRS took exception to this, taking a 10% bite from the $12,063 in distributions used to pay off the earlier student loans and credit card bills.
Linda argued that the penalty shouldn't apply to any part of the distribution, since the money she withdrew equaled her combined qualified education expenses. The IRS claimed that the exception applies on a year-by-year basis and shouldn't cover the whole transaction. True, Linda took that early distribution in 2001, but only $7,937 paid for education expenses incurred in the same year. Anything else, the IRS said, was subject to the 10% penalty.
In addition, the other portion of Linda's IRA distribution didn't directly pay for education expenses; instead, it paid the credit card bills she'd run up to originally fund those expenses. Since the distribution wasn't going straight to education, the IRS asserted that the 10% penalty still applied. The tax court sided with the IRS.
Linda slipped up when she tried to aggregate several years' worth of education expenses, direct or indirect, into a single payment in a single year. If the 10% penalty exception wasn't clear on this point before, it's certainly crystal clear now.
Linda's use of loans and credit cards to pay for her qualified education expenses wasn't really the problem. There's nothing in the tax code to prohibit incurring qualified education expenses, paying them via credit card, then taking a penalty-free IRA distribution to pay them off -- so long as it all happens in the same year.
It wasn't unreasonable for Linda to think she could lump all her educational expenses in one payment, though. Common sense and intuition aren't exactly the basis for the tax code -- which makes interpreting it properly much more an art than a science.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns, so long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.