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Tax Talk with George Saenz

Ask the tax adviser

Cashing in an IRA to pay college costs

Dear Tax Talk:
I withdrew $11,000 dollars from an IRA to pay off a student loan. I did not claim the money as income, nor did I show it as an expense. The Internal Revenue Service now has recalculated my return and says I own additional taxes. That may be correct, but if it is, can I claim the amount that I paid off (which was $11,000) to offset some of the new taxes that are due?
Don

Dear Don:
I'm guessing you didn't pay off student loans that relate to an education in taxes.

You might not have reported the individual retirement account withdrawal on your tax return, but the IRA custodian reported to the IRS. This is why the IRS recalculated your tax and is billing you for additional tax, penalties and interest. You're correct in not deducting the student loan on your original return, as it was not then and is not now a tax deduction or offset to the IRA withdrawal.

An early withdrawal (that is, money taken out before age 59½) from an IRA is subject to a 10-percent penalty in addition to income tax due on the withdrawal. The payment of qualified higher education expenses can eliminate the penalty on early IRA distributions.

Unfortunately, only payments of tuition, books, fees, supplies and sometimes room and board paid during the year of the withdrawal are considered higher education expenses. The payment of a student loan relating to prior years' expenses is not a qualified higher education expense.

Consider that:

1. The IRA can accumulate tax-free,
2. Student loans tend to have low interest rates,
3. In certain circumstances the interest on the student loan is deductible and
4. The income tax and penalties due on a withdrawal can be 25 percent to 50 percent of the withdrawal.

It never makes sense to withdraw from an IRA to pay off a student loan.

-- Posted: June 4, 2002

Read more Tax Adviser columns
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See Also
Bankrate.com's IRA Center
Tax-free ways to save for education
Four reasons not to tap your IRA
More tax adviser stories
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