Back to School: Educational Expense Exception to the 10% Penalty (Part 4 of 4)

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

Can you believe it? We’re now 7 full months into 2012 already. And while there’s more fun in the sun to be had before summer comes to an end, August has traditionally signaled the start of the back to school season. With that in mind, we thought we’d spend a little time talking about the educational expense exception to the 10% penalty.

We first discussed the basic tenets of the exception, whose expenses and what types of expenses qualify in the first installment of this series. CLICK HERE to read the first article on the educational expense exception to the 10% early IRA distribution penalty.

In the second part of the series, we delved into what is considered an “educational expense” and what type of schooling is covered under the exception.

And in the third installment, we got a little more technical and talked about the exception’s use with 401(k)s, Traditional IRAs as well as SEP and SIMPLE IRAs. We wrap up the series below by tying a bow on the exception and answering questions about IRA distributions, scholarships and any traps you should be aware of before using the educational expense exception to the 10% early distribution penalty.

Does the educational exception apply to Roth IRA distributions?

Yes, although you may not need to use it. Regular Roth IRA contributions (money contributed directly into a Roth IRA) can be withdrawn at any time, for any reason, without any penalty or income tax. Additionally, any Roth IRA funds attributable to Roth conversions made more than 5 years earlier can also come out income tax and penalty free for any reason. If on the other hand, you are under 59 ½ and are taking a Roth IRA distribution consisting of either recent Roth conversions (less than 5 years) or of earnings, the 10% penalty would generally apply. The educational expense exception could be used to get out of any penalty owed. You will, however, owe income tax on any portion of you distribution attributable to earnings.

When does the IRA distribution have to be taken?

There is no specific day or month requirement (i.e. within 60 days or 4 months). However, the educational expense must be paid in the same year as the distribution was taken from the IRA. The year, in this case, is the calendar year. So, for instance, if you pay a college tuition bill in January of 2013 that qualifies for the education expense exception, you can take a distribution from your IRA anytime between January 1, 2013 and December 31, 2013 and have it qualify for the exception.

What happens if you receive a scholarship?

Any scholarships received will reduce the amount of IRA distributions that you are eligible to take without getting hit with the 10% penalty. For instance, suppose you had qualifying educational expenses of $20,000 but received a scholarship for $5,000. You could take a penalty-free distribution from your IRA of up to $15,000 ($20,000 – $5,000) to help pay for your unreimbursed expenses.
If the scholarship came as an unexpected surprise (how nice would that be?) after you already took the distribution from your IRA, do you have any options? Probably. So long as you are still within 60 days of your distribution and had made no other rollovers into or out of the account you took the money from in the 365 days before the distribution, you could roll back any of the excess to an IRA or other retirement account.

Are there any traps I need to be aware of?
There are always traps to avoid, that’s why working with a knowledgeable advisor who can help you steer clear of hazards is so important! Here’s just one of the many traps you need to avoid… Suppose that in December of this year you receive a college tuition bill for the Spring 2013 semester – that’s fairly standard. Like many people, you decide to pay with the bill with a credit card (hey, why not get the points, right?) and do so on December 22, 2012. In January of 2013, your credit card bill arrives and you don’t have the money to pay for it.

Well, since the bill is for college tuition, so you decide to take a distribution from your IRA (in 2013) because it will be an exception to the 10% penalty, right? WRONG. Even though you need to come up with the cash in 2013, the bill is considered paid when you used your credit card in 2012. Now the expense and the distribution are not in the same year as required, and the distribution from your IRA would be subject to both tax and the 10% early distribution penalty, assuming no other exception applied.