It’s back to school time and the costs for college are quickly mounting. Where is the money going to come from? Many times individuals look to their retirement funds to pay higher education expenses. Can this be done and is it a smart move?

There is an exception to the 10% early distribution penalty for higher education expenses but, the exception to the penalty only applies to distributions made from IRA accounts, including SEP and SIMPLE IRAs. The exception will never apply to a distribution from an employer plan.

A distribution from an IRA of pre-tax funds will be taxable. The distribution must be made in the year the expense is incurred. In the case of a loan or expenses put on a credit card, distributions made in later years to pay off those bills will not qualify for the penalty exception. The exception will apply to out of pocket expenses, i.e. expenses reduced by financial aid, loans, grants, etc.  Qualified higher education expenses can include tuition, room and board, required fees, books, and supplies. There is no dollar limit for this exception. Computers and related technology are also a qualified educational expense even if they are not specifically required by the school. The exception applies to the IRA owner, their spouse, and any child or grandchild of either the IRA owner or the spouse.

The bigger question is “Should you use retirement funds to pay for education?” Once funds are removed from a retirement plan, it is very difficult to make up that loss. Contributions are limited to $5,500 a year, $6,500 if you are age 50 or older during the year. IRA contributions must stop once you reach the year you turn 70 ½, even if you are still working. In addition to the loss of the amount of the withdrawal, you also lose the earnings on that amount – each year – and the earnings on the earnings. Compounding is a powerful force in a retirement account. You are most likely digging a hole that you can never climb out of.

As a friend once said to me, “You can borrow to finance college; you cannot borrow to finance your retirement.” This is so true. You cannot borrow to pay your rent, utilities, medical expenses and to buy groceries. An IRA should only be used as a last resort when all other sources of funding have been exhausted. But if you are going to use your retirement funds to finance an education, be sure you do it right. Make sure you follow the rules above.