When you put money in a traditional Individual Retirement Account, the tax on that money is deferred until you exit the workforce If you withdraw the money before retirement, you'll be taxed and penalized 10 percent of the amount withdrawn unless your withdrawal falls under a list of IRS exceptions. The Higher Education Act of 1965, allows you to leverage your IRA for education exceptions under certain conditions.
Education Exceptions to Withdrawal Penalties
As explained in IRS Publication 970, Section 9, you can take distributions for qualified higher education expenses without having to pay the 10 percent penalty. Unfortunately, except in one circumstance, the education exception only applies to expenses paid at the time they are incurred, not the repayment of funds borrowed to pay for education expenses.
This may seem unfair, but here's why: the education exception only applies to real-time education expenses like books and tuition. When you borrow money for your education you have an obligation to pay interest and closing costs on that loan. Often the interest costs are capitalized and become an infrangible part of the amount due -- that is, you you really can't tell how much of the loan amount is an educational expense and how much is interest and costs. Interest and loan costs aren't qualified educational expenses and are subject to withdrawal penalties.
A Limited Penalty-Free Exception
Chartered Financial Analyst Dr. Don Taylor, writing for Bankrate, notes that there is a single limited exception to the general rule regarding penalties for IRS withdrawals to repay student loans. If the loan is solely for qualified higher education expenses, is taken out during the current calendar year and is used to repay education expenses that were also incurred in the current year, you can repay the loan with a penalty-free distribution from your IRA. You still have to pay income taxes on the amount distributed.