IRAs (Individual Retirement Accounts), 401(k) plans, and other retirement accounts are supposed to be used for retirement purposes, and there is a 10% penalty on early withdrawals to persons younger than 59-and-a-half years old. For instance, a person who withdraws $500 from a traditional IRA would pay taxes on having $500 of additional taxable income, plus a $50 early withdrawal penalty.
Like many other tax breaks, Congress decided to add a huge number of complicated exceptions to the 10% early distribution penalty. For example, a "first-time homebuyer" may withdraw up to $10,000 from retirement accounts to buy his or her "first" home, except that a "first-time homebuyer" is defined as someone who has not owned a home in the past two years.
Apparently, helping "first-time homebuyers" sounds a lot better than helping "people who already bought houses but sold or abandoned them 24 months ago," akin to born-again virgins.
A separate exception in Internal Revenue Code section 72(t)(2)(E) provides that IRA distributions can be used to pay for higher education expenses and avoid the 10% early distribution penalty. Higher education expenses are broadly defined, to include college or graduate school tuition, fees, and room and board, for the taxpayer, a spouse, a child, or a grandchild. The child or grandchild does not have to be a dependent. In fact, the IRA distributions do not have to be traced to the higher education expenses and can even be made after the expenses were paid, as long as the distributions are less than the amount of the expenses for the same year.
Even though "higher education expenses" are defined very broadly, the statute imposes an oddly strict limitation at the same time, in that the distributions can only come from IRAs and not from other types of retirement accounts in order to qualify for the education expenses exception. Congress did not explain its rationale when the exception was created in 1997. Congress at the time was working on "education IRAs," a type of "retirement" account that could be only used for educational expenses (now called Coverdell ESAs), and it decided to throw other IRAs into the pot as well.
In the landmark case of McGovern v. Commissioner, T.C. Summary 2003-137, the under-59-years-old taxpayer received around $28,000 from his employer retirement plan (a Thrift Savings Plan, like a 401(k) plan for federal government employees). He rolled over part of it tax-free to an IRA, and he used $12,880 to pay for tuition at Villanova law school.
The Tax Court concluded that he had to pay a 10% early withdrawal penalty of $1,288, because the education expenses exception applied only to IRA distributions and not to distributions from other retirement plans. It did not matter that the taxpayer could have simply rolled over the entire amount tax-free to his IRA, and then used a $12,880 IRA distribution to pay for tuition and qualified under the education expenses exception. He was liable for the 10% early withdrawal penalty because he paid the law school tuition in one step, instead of pointlessly creating two steps.
Section 72 Annuities; certain proceeds of endowment and life insurance contracts.
(t) 10-percent additional tax on early distributions from qualified retirement plans.
(1) Imposition of additional tax.
If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c) ), the taxpayer's tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income. ***
(2) Subsection not to apply to certain distributions.
Except as provided in paragraphs (3) and (4), paragraph (1) shall not apply to any of the following distributions:
(E) Distributions from individual retirement plans for higher education expenses. Distributions to an individual from an individual retirement plan to the extent such distributions do not exceed the qualified higher education expenses (as defined in paragraph (7)) of the taxpayer for the taxable year. ***
(7) Qualified higher education expenses. For purposes of paragraph (2)(E) —
(A) In general. The term “qualified higher education expenses” means qualified higher education expenses (as defined in section 529(e)(3) ) for education furnished to—
(i) the taxpayer,
(ii) the taxpayer's spouse, or
(iii) any child (as defined in section 152(f)(1) ) or grandchild of the taxpayer or the taxpayer's spouse,
at an eligible educational institution (as defined in section 529(e)(5)).
(B) Coordination with other benefits. The amount of qualified higher education expenses for any taxable year shall be reduced as provided in section 25A(g)(2).