Back to School On a 401(k)

By Albert B. Crenshaw
Sunday, January 22, 2006

Thinking of quitting your job and going back to school?

Thousands of Americans do that every year, but for many, finding the necessary money is a stretch. So, as they run their hungry eyes across what assets they have, their gaze often alights on their 401(k) retirement savings accounts.

But while Congress seems to have envisioned cases in which workers might need to tap retirement savings to pay for school, it provided only its usual haphazard, disjointed help.

Thus, workers who want to tap their retirement accounts must be careful to do it the right way, or they may find themselves subject to early-withdrawal penalties that eat up 10 percent of the money they pulled out for school. The same thing can happen to workers who tap their accounts to buy a first home.

An Arizona man recently learned this the hard way, having to pay more than $3,000 in extra tax. However, though it didn't help him, the U.S. Tax Court kindly spelled out for others the right way to get at certain retirement money without penalty.

The case arose after the man quit his job in 1999 and returned to school to obtain a PhD. In 2001, he withdrew $30,368.86 from his 401(k) account at his former employer and used the money to pay for school expenses and to buy his first home.

He reported the $30,368.86 as income on his 2001 return but paid only the normal tax on it. That was fine, said the Internal Revenue Service, but he should have also paid a 10 percent penalty -- $3,036.80 -- for an early distribution.

The man took his case to the Tax Court, but the court said that, while "we sympathize with [his] confusion," the law allowing penalty-free withdrawals for higher-education expenses and first-time home-buying applies to "individual retirement plans," not 401(k) plans.

"An individual retirement plan is commonly referred to as an IRA," the court observed, and an IRA is not a 401(k). The man's argument "that the difference between a 401(k) and an IRA is a mere matter of form does not change the fact that the amount received by [him] was not a distribution from an IRA," the court added.

Thus, it concluded, he was liable for the penalty.

The court also noted that the man was younger than 59 1/2 , the age at which account holders can start making penalty-free withdrawals for any reason.

The clear message here is that taxpayers who wish to tap 401(k) accounts for college or first-time home buying should be careful, said Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal for tax professionals, which first called attention to the case.

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