By NEIL DOWNING
The Providence Journal
01-SEP-06
Planning to withdraw money from your 401(k) or other such retirement-savings plan to pay for college expenses?
Be careful, because you could be slapped with a penalty, said Bob Scharin, senior tax analyst at RIA of New York, which provides tax information and software to accountants and other professionals.
A former flight attendant in New York found out about this rule the hard way. Here's what happened, according to U.S. Tax Court records:
Linda L. Domanico worked for Trans World Airlines and took part in TWA's 401(k) plan. She left her job in 1996 after suffering an injury on board an aircraft.
In 2001, after American Airlines had taken over TWA, she received a notice that essentially gave her three options regarding the balance in her 401(k): transfer it to another such plan, move it to an IRA or withdraw it.
Domanico had been taking classes to become certified as a schoolteacher. She decided to withdraw the $40,457 balance from her 401(k) and used the bulk of it to pay for her higher education expenses.
On their federal income-tax return for 2001, she and her husband, Anthony, correctly reported the $40,457 withdrawal as income, subject to tax.
But they failed to pay the additional 10 percent penalty for early withdrawal, which, in this case, came to about $4,046.
The Internal Revenue Service sent them a bill, the couple disputed it and the case eventually wound up in Tax Court.
The couple argued that the penalty doesn't apply when withdrawals are used for higher education expenses. Unfortunately, they were wrong.
An exception to the penalty rule does exist for higher education costs. But the exception applies only for withdrawals from IRAs, not from a 401(k) or other such retirement-savings plan, Judge Robert N. Armen Jr. ruled.
"Although Mrs. Domanico used her 401(k) plan distribution for a commendable purpose ... the distribution does not qualify for the higher education expenses exception ... because the distribution was not from an IRA," Armen wrote in his decision earlier this year.
You can withdraw money from a 401(k) or other such retirement plan at work and escape the penalty, but only under certain circumstances _ if you leave work after you turn 55, or if you're disabled, for example.
But none of those exceptions applied in Domanico's case. (At the time of the withdrawal, she hadn't reached age 55, and she wasn't disabled.)
What about the exception for higher education expenses? It applies "only to distributions from ... IRAs, and not to all qualified retirement plans," Armen wrote.
This is an important point to keep in mind, said Scharin, the analyst at RIA, a unit of Thomson Corp. The rules are complicated, he said. But when making withdrawals, "People either don't think at all" about the rules involved, or just assume that the rules for 401(k) plans are the same as those for IRAs, Scharin said.
They're not. If you plan to tap your 401(k) or other such account to pay for college costs, consider transferring your 401(k) account balance directly to an IRA first. If you later withdraw money from your IRA to pay for college costs, it'll still be subject to tax, but won't be slapped with the 10 percent penalty.
(Contact Neil Downing bt e-mail at moneyline(at)projo.com.)
(Distributed by Scripps Howard News Service, www.scrippsnews.com.)
