More on education and retirement account penalties

In an earlier article, I discussed some of the ways to avoid the 10% early distribution penalty for certain retirement account withdrawals. A reader had this followup question:

Hello, I was reading your article about using room and board costs as an education expense to reduce the 10% penalty on an early distribution from an IRA – if the student rents an apt not run by or affiliated with the college can these expenses be used as qualifying education costs to reduce the 10% penalty or does the student have to live and eat on campus?

Short answer: Yes, the costs for the off-campus apartment are allowable for this penalty exception.

There is a limitation on these costs. They cannot exceed the “allowance for room and board (…) that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period (…).” (See IRS Publication 970, page 58)

In other words, you should check with your educational institution to determine what is their official “allowance for room and board.” This shouldn’t be too hard to find. For instance, I checked the website at CSU East Bay, where I got my Masters Degree in Taxation, and it took less than a minute to find this page outlining the costs of attendance. (“Costs of attendance” is a good term to use when searching or inquiring with a representative of the school.) At the bottom, they explicitly state the estimated cost of room and board for off-campus housing is $12,414 (at the time I checked). Nearly any school eligible for federal financial aid should be able to provide this number. It goes into the equation that federal aid programs use in determining how much aid students are eligible to receive at a given institution, so institutions may actually be required to provide it. (I’m not 100% sure if they’re required to provide it, but I do know it’s very common.) So in my case, since I’m enrolled at least part-time at the University, I could use up to $12,414 in room/board costs during an academic year to offset any penalties related to an IRA withdrawal. (Of course, I must actually have those costs. If my actual costs are less, I could only take the lower amount.)

Publication 970 makes it clear that off-campus costs are allowed in how they describe the amount eligible for this 10% penalty exception. The second limit on the exception (in addition to the exception I just quoted above), is the “actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.” Clearly, if this exception were limited to only housing costs paid to the university, there would be no need to provide both limits.

So check with the educational institution to find out what their official “allowance” is for room/board, and then you can deduct that amount or the actual costs, whichever is lower. (And do your best to find those grocery/restaurant receipts…the rent will be easy, but you might miss some expenses in the food area. Still a lot better than no exception!)


2 Responses to More on education and retirement account penalties

  1. Jack Money says:

    Thanks for the reply, this allows me to exclude about $2,900 0f penalty – another question is if ‘Prepaid Tuition’ paid over a period of prior years to lock in lower years tuition costs and paid out to the college in later years as tuition is due is eligible to be used as education costs in the year allocated to the college for tuition, in the education credit calculation?

    • class5tax says:

      Assuming the prepaid tuition program is through a 529 plan (by far the most common scenario), then the disbursements of prepaid tuition are also eligible for the penalty exclusion in the year payments are disbursed from the account and paid to the college (page 58 of IRS Pub 970). If you are dealing with a distribution from a 529 plan (or ESA), it’s a good idea to have a professional review the tax treatment. It’s often better to recognize income on the distribution, which makes you eligible to claim credits that are usually far more valuable. Balancing the different tax treatments available for educational expenses, and maximizing the value of credits and exclusions, is beyond the capabilities of any tax software I know of–including the professional grade software that costs thousands of dollars. Even many “professionals” aren’t able to do it…like most employees of tax chain stores who are often dependent on software without a deep understanding of what’s going on “under the hood.”

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