It's usually no problem finding a tax-advantaged college savings program that lets you save with after-tax dollars. The popular Section 529 plans, Coverdell education savings accounts and life insurance cash values all compound tax-free when used for qualified higher education expenses. If you want to use pre-tax dollars, you can use IRAs, 401(k)s and other qualified retirement plans, which generally allow penalty-free withdrawals for college. However, you won't escape income tax entirely — you will still need to pay income tax on these accounts when you withdraw the money.
Some 401(k) plan sponsors allow in-service distributions for the purpose of funding education expenses for yourself or loved ones, but others do not allow it. Check your plan's rules for specifics. If your plan allows, you can tap your 401(k) plan to fund college expenses — and do so without a penalty if your plan rules allow for education funding. However, you still have income tax liability, and your plan administrator will withhold 20 percent from any distributions you take out and forward it to the IRS. Generally, rules for 403(b) tax-sheltered annuities are similar to those for 401(k) plans. Check your plan sponsor's rules for specifics.
Normally, you have to pay a 10 percent excise tax on withdrawals made prior to age 59 1/2. However, the IRS allows for penalty free withdrawals for "hardship conditions." Withdrawals to pay college costs for yourself and a loved one qualify. However, as with 401(k) plans, you will still owe income tax on any distributions you make from IRAs and similar accounts, including SIMPLE IRAs and SEP IRAs.
If you take money out of a tax-deferred savings vehicle to pay for college, you lose the benefit of the tax-deferral on those dollars forever. Some planners urge caution against drawing down more from your IRA for college than you can afford. Some people prefer student loans, home equity loans, personal loans or loans against life insurance policies to fund college expenses. Some accountants suggest guarding against the danger of overspending from IRAs earmarked for retirement by using separate IRAs for retirement and education savings.
Tax-Deductible Educational Expenses
One loophole you may be able to take advantage of is funding college expenses for yourself. Certain education costs are tax-deductible as unreimbursed employee business expenses, or as business expenses on your Schedule C. This allows you to save using pre-tax dollars from your IRA or 401(k) plan, and still pay for the program using essentially pre-tax dollars. You will still have to declare the income you take out of these accounts, but it's a tax wash — at least to the extent that certain educational expenses are deductible. To deduct educational expenses, however, the education must be for the purpose of enhancing your potential or income in your current profession. Furthermore, the education cannot qualify you for a new profession. For example, if you are a pilot, you can deduct the costs of new certifications and flight training. You cannot normally deduct these costs, however, if your current profession is in medicine or food service.
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