IRAs and 529 Funds Don't 'Compute'

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This week, Gail cautions parents that the laptop they bought for their kid with IRA money might not be a 'qualified' expense.

Dear Gail,
I’m hoping you can settle an argument. Our first child just started college. Even though we knew it was coming, it was still a bit of a shock to write that first check! We also bought him a laptop.

Fortunately, that’s a one-time expense and not something we’ll have to pay for every semester. I want to reimburse our checking account by withdrawing the money for his laptop from my IRA. We’re both younger than 59 ½ so my wife says we’ll have to pay a penalty for this. She thinks you can only withdraw an amount equal to the tuition. What do you think?



Dear David —

A tax court ruling handed down last month should send chills down the spines of parents with kids in college. It indicates the I.R.S. is taking a much tougher stand than expected regarding the kinds of college expenses that qualify for a penalty-free withdrawal from an IRA. This ruling also has implications for tax-free use of 529 money.

First, a bit of background. Section 72(t) of the Internal Revenue Code lists a number of circumstances that allow you to withdraw money from a traditional IRA before age 59 ½ and avoid the normal 10-percent early withdrawal penalty (you would still owe any income tax due). Among these is “qualified higher education expenses.” The student can be the taxpayer him/herself, the taxpayer’s spouse, or any child or grandchild of the taxpayer or taxpayer’s spouse. Finally, the education expenses must be paid to “an eligible educational institution.”

Section 72(t) states that it uses the same definition of “qualified higher education expenses” as Section 529 -- the portion of the tax code that deals with- you guessed it- 529 college savings plans. The explanation, found under Section 529(e)(3), is both straightforward and vague. The part that applies here states:

“The term ‘qualified higher education expenses’ means- (i) tuition, fees, books, supplies, and equipments required for the enrollment or attendance of a designated beneficiary at an eligible educational institution;”

If you don’t spend a lot of time perusing the tax code, the problem probably doesn’t jump off the page. Here’s a hint: it hinges on the word “required.” As James and Mary Gorski found out, the IRS and the tax court are applying a very narrow and literal definition to this word.

In 2001 the Gorskis, who were both under age 59 ½, withdrew $25,000 from an IRA to pay for daughter Kathleen’s college expenses. Their income tax return was audited and the IRS argued that they owed $2500 as the penalty for an early withdrawal (10 percent x $25,000).

In court, the Gorskis proved that $7,017 of the IRA distribution was used to pay for Kathleen’s tuition, fees, and room and board — all “qualified higher educational expenses” since her university was an “eligible” institution.

The Gorskis also argued that the additional $1585 they spent for a computer for Kathleen was a “qualified higher educational expense,” claiming it was a “necessary tool or equipment.”

While the court conceded that “neither the Internal Revenue Code nor the applicable regulations provide specific guidance on whether a computer is a qualified higher education expense,” it said the real issue is whether it was “necessary” for Kathleen’s attendance at the university.

First, the school did not require students to have a computer; in fact, it provided a limited number of computers for students to use in the library. Second, the Gorskis admitted that Kathleen was not enrolled in any classes that required her to have her own computer. Thus, having a personal computer was more of a convenience than a requirement.

Joe Hurley, CEO and founder of , says he was surprised by the ruling. “The I.R.S. hadn’t been that specific before. Informally, they had suggested they’d be fairly flexible in what was a qualified expense.”

And here’s fair warning for anyone who just spent a bundle outfitting their kid’s dorm room with all the comforts of home: the court said the $700 the Gorskis spent on houseware, appliances, furniture, and bedding was not “required” by the university and, therefore, did not meet the definition of qualified higher education expense.

Finally, the Gorskis lost another point most would never expect: the additional $400 they said they spent on books for their daughter was disallowed. Part of the problem was the Gorskis apparently didn’t have all of the receipts to prove they had spent this money. In addition, none of the books were required (there’s that word again!) for Kathleen’s enrollment or for any specific class. In other words, a dictionary might be a handy thing to have, but if it isn’t a requirement of admission, you can’t claim it is a “qualified higher education expense.”

The court said the remainder of the Gorskis’ IRA withdrawal also failed to meet the definition of “qualified educational expense” and ordered them to pay the 10 percent penalty tax on a total of $17,983. There would also be interest charges because this stemmed from the Gorskis’ 2001 tax return.

While the Tax Court opinion applies only to the specific taxpayers involved, “it points out the risk of including these types of expenses,” cautions Hurley, who is also a CPA. “It appears that if a computer or book is not a requirement set out by the college, it doesn’t count as a qualified higher education expense.”

And, since 592 plans use the same definition of “qualified higher education expense,” the safe approach would be to use the same criteria to determine whether you can use a 529 withdrawal to pay for a computer or any other college-related expense that is not specifically spelled out in the tax code.

Remember: withdrawals from a 529 plan that are used to pay for qualified higher education expenses are tax-free (through 2010); the earnings portion of withdrawals that do not meet this definition is subject to ordinary income tax plus a 10 percent penalty.

Sorry to take such a circuitous route to get to your question, David, but as you can see, the answer is “maybe.” The key is that you have a piece of paper to substantiate your claim that a laptop is “required” in the event you get audited.

Hope this helps,


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