While the government has created tax loopholes for us to use, and wants us to use them, they certainly don’t make it easy! Here’s a story about a tax deduction gone horribly wrong.
Although IRA funds are meant for retirement, the government does recognize that there are times people need to tap into these funds ahead of time and allows for this to happen. What happens when you withdraw funds early is that you face both an income tax hit as well as an early-withdrawal penalty. The tax you pay on the withdrawal will be calculated based on your current ordinary income tax rate, and the early-withdrawal penalty adds another 10 percent – so if you’re in the highest tax-bracket of 35%, you’d be looking at almost half of that withdrawal being paid out in tax!
When you withdraw funds for certain government-approved reasons, on the other hand, you can escape that early-withdrawal penalty. However, it’s crucial that you fully understand those reasons!
In a recent case I read, a taxpayer’s misunderstanding led to an unexpected tax hit, when the taxpayer withdrew $22,000 to pay for school fees for his three sons. The IRS does allow IRA holders to withdraw funds, penalty-free, for tuition and certain other approved expenses, and in this case, having no education funds in place for his kids, nor the ability to receive financial aid, our taxpayer decided to take the hit from his pension fund, rather than go to third-party borrowers for these education costs.
The problem here was that the taxpayer misunderstood the loophole. He thought it applied to all schooling, and so a good portion of his IRA withdrawal was paid for his son’s tuition at a private high school. However, the rules say that only higher-education tuition qualifies – and under the IRS’s definition, high school is not higher education, even if it is a private school.
When the taxpayer claimed the entire IRA withdrawal as penalty-free on his tax return the following year, the IRS objected. The taxpayer argued that because the high school was a private school and was designed specifically to prepare high-achieving students for university and military studies, it qualified as a “higher-education” expense.
As far as the Tax Court was concerned, the issue was quite clear – unless the son was going to receive either an associate’s degree or a bachelor’s degree upon graduation, the school was not a qualified post-secondary institution, not matter how polished its credentials. The taxpayer had to take the extra penalty hit on his return for the premature withdrawal of IRA funds.