The federal government offers tax incentives for people who want to use individual retirement account, or IRA, funds to pay for higher education expenses for their children or grandchildren. You can either set up an education IRA to hold your relative's college funds until he turns 18 or use funds from your own IRA to pay for college. Your use of your IRA for college funds is subject to rules and restrictions; if you follow all the rules, you won't pay taxes on distributions for this purpose.
Qualified Educational Expenses
You can take money out of your IRA for higher education expenses only if the expenses are considered qualified educational expenses. If you or your relative is enrolled in school on at least a half-time basis, then tuition, books and required fees are considered qualified expenses, as are room and board. Students who are enrolled on a less than half-time basis can't use IRA funds for room and board.
Financial aid packages take precedence over IRA withdrawals. For example, if a student has a loan or scholarship for $10,000, this financial aid must be applied to the student's costs before you can use IRA funds to cover educational expenses. Thus, if the student's total expenses are covered completely with a scholarship or a loan, you can't use IRA funds to pay for school.
If you've put money into an education IRA for your relative, you must use these distributions before taking distributions from your personal IRA. You can deposit $500 per year into an education IRA for your child until the child reaches the age of 18. Withdrawals from an education IRA for the purpose of paying for higher education are not taxable; if the child withdraws money for other reasons, he must pay tax on it. If the child doesn't use all of the money in his education IRA by the time he finishes his education, he can roll it over into the education IRA of another family member without paying taxes on it.
Neither education IRA withdrawals nor regular IRA withdrawals are subject to a tax penalty if the money is withdrawn to pay for higher education. All withdrawals from education IRAs for other purposes trigger a 10 percent penalty tax -- plus the distributions are taxable. If you are under the age of 59 1/2, you are subject to the same penalties for withdrawing money from your regular IRA unless you qualify for a hardship exemption from the 10 percent penalty.
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