IRA and 529 Penalties

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Question:  If I withdraw money from my IRA account to pay for my daughter’s college, will I be charged with a penalty?  I am 55 years old.

Answer:  Withdrawals you make from an IRA account before you reach age 59 ½ will normally result in a 10% penalty.  However, there are exceptions, including for education. You can use IRA money to pay for qualified higher education expenses for yourself, your spouse, your children, and your grandchildren.  Qualified education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible education institution.  If the student is at least a half-time student, you can also deduct room and board expenses. Keep receipts and be prepared to defend your case if the IRS should ask attempt to impose a penalty.

Question:  I am the owner of a 529 College Savings Plan for my son and will be withdrawing money this year to use toward a down payment on a new home.  I know that withdrawals from an IRA that are used for a first-time home purchase can be penalty-free.  Is this also true for college savings plans, and if not, how much tax and penalty will this cost me?

Answer:  This is an interesting question because 529 college savings plans, which are obviously set up to pay for college, can sometimes provide a source of immediate cash for other needs, such as yours. 

The tax advantages of 529 plans are tax-deferred growth and tax-free withdrawals if the money is used for qualified education expenses.  If you use money from a 529 plan for non-qualified education expenses, you will owe income tax and a 10% penalty on some, but not all, of the money.  Here is how the tax and penalty applies:

Any withdrawal from a 529 plan will consist of two parts:  contributions and earnings.  You only pay tax and penalties on the earnings.  For example, let’s say that you are the owner of a 529 plan and over the years have contributed a total of $60,000.  Today the plan is worth $100,000.  You then decide to withdraw it all for non-qualified expenses (e.g. down payment on a house).  60% of the withdrawal amount is a tax-free return of principal. You only pay tax and a penalty on 40% ($40,000 of the $100,000), which represents the earnings in the account. 

529 plans were established by Congress to help pay for higher education.  But using a 529 plan for purposes other than qualified education expenses will sometimes make sense just like when your doctor prescribes a medication for a condition other then what that medication was originally intended for (“off-label” use). 

This makes sense for you because you are in a 33% combined federal and state tax bracket, you have a secure job, and all of your savings, which total $550,000, are in a fully taxable retirement account.  You have a choice of taking the $100,000 you need from your 529 Plan or your retirement account. If you choose the 529 plan, you will pay taxes and penalties on $40,000 totaling $17,200.  If you choose to take the funds you need from your retirement account, you will pay taxes and penalties on $100,000 totaling $43,000, which is more than twice as much.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to ken@montereypw.com.