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.

Taxpayers who expect to stay with their employers may be able to make hardship withdrawals from their 401(k) accounts, though that means paying the tax and penalties. They also may be able to borrow without tax or penalties. However, such loans require repayment with interest, which can cause a cash-flow problem. Also, a worker who quits or is fired may find the loan due immediately, and any unpaid balance is deemed to be a withdrawal subject to both taxes and the penalties the worker was trying to avoid in the first place.

Those who leave their employers -- or, Scharin noted, want to tap 401(k) balances they have at previous employers -- should roll the accounts over to IRAs.

That can be done without incurring tax if, again, it is done right. The best way is a trustee-to-trustee transfer in which the money is sent directly from the 401(k) account at the employer to the institution that will hold the IRA.

Once in the IRA, the money can be withdrawn for college or first-time home-buying without penalty.

However, Scharin cautioned that students should be careful not to withdraw more in one year than is needed to cover their higher-education expenses in that year. The extra would be subject to the 10 percent penalty.

"If you're going to spend two years in school, don't pull all the money out at once," he said. Instead, take out only what you need for the first year, and leave the rest in until the second year.

Taxpayers should also be aware that the rules allow penalty-free withdrawals from a person's IRA to pay not only his or her own college expenses, but also those of a spouse, child or grandchild, Scharin said.

For home buyers, the court noted one other restriction -- there is a $10,000 lifetime limitation on penalty-free withdrawals for this purpose.

One other point: The Tax Court decision was what it calls a "summary opinion" under the court's small-tax-case procedure, which means it may not be appealed or be used as precedent or cited as authority in other cases. The opinion in the case, Keith Lamar Jones v. Commissioner of Internal Revenue , is available on the court's Web site, http://www.ustaxcourt.gov/ . Click on opinions search at the top, type Jones into the case name keyword field and look for Keith Lamar Jones.

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Members of the Senate are urging the Treasury and IRS to suspend or modify the IRS Criminal Investigation division's controversial program that summarily blocks refunds it considers likely to be fraudulent without telling the taxpayer why.

Finance Committee Chairman Charles E. Grassley (R-Iowa) last week wrote Treasury Secretary John W. Snow to "strongly urge you to take immediate steps to provide taxpayers notice within 90 days of an action that freezes a refund." And Democrats John F. Kerry (Mass.) and Barack Obama (Ill.) urged IRS Commissioner Mark W. Everson to suspend the program temporarily and to explain the reason behind it, along with the rationale for targeting low-income workers who claim the earned-income tax credit. And on Friday, Senate Minority Leader Harry M. Reid (D-Nev.); Max Baucus (Mont.), the senior Democrat on the Finance Committee; and Appropriations Committee member Patty Murray (D-Wash.) were asking why problems with the program, which have been brought up before, haven't been addressed.

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The IRS is trying to alert taxpayers in the District, Maryland, Virginia and nine other states that they should send their returns to new addresses this year. Those who got instruction booklets from the IRS in the mail and use the labels provided will not be affected, nor will e-filers.

However, paper filers who address their own envelopes should note that 2005 returns from Delaware and Virginia should go to the IRS Center in Atlanta; those from the District and Maryland go the IRS Center in Andover, Mass.; those from Ohio go to the center in Kansas City, Mo.; those from Kansas, Mississippi and West Virginia go to the center in Austin; and those from Colorado, Nebraska, New Mexico and South Dakota go to the center in Fresno, Calif.