The Roth IRA is one of the most powerful tax planning tool available.  The primary advantage of saving via a Roth is that a distribution from the plan is tax-free so long as you are over the age of 59 1/2 and the Roth IRA has been opened at least five (5) years (a “qualified Roth IRA distribution”).  If a Roth IRA distribution is not “qualified,” then the distribution could be subject to income tax plus a 10% early distribution penalty, unless a hardship exception applies. This article will explain how the Roth IRA works and then discuss the available hardship exceptions to taking a distribution, including for “qualified education expenses.”

Roth IRA Basics

The Relief Act of 1997 introduced the Roth IRA. It is an after-tax IRA which allows any US person with earned income under a set income threshold (under $153,000 if single and $228,000 if married and file jointly in 2023) to make after-tax contributions up to $6,500 or $7,500 if at least age 50. Also, with a Roth IRA there are no required minimum distribution at age 73 like a traditional IRA.  In other words, if you made an investment into any capital asset, such as stocks, real estate, and even cryptos, the income is generated without tax and you would be able to pull money out of the Roth IRA tax-free once you are qualified.

Roth IRA Hardship Exceptions

One can take a distribution from a Roth IRA at any time. However, one would be subject to tax and a 10% early distribution penalty if the distribution is not qualified. Note the income tax and penalty would only apply to the earnings since Roth IRA contributions are after-tax and can always be taken as a distribution tax free.

However, if the Roth IRA owner can satisfy an IRS approved hardship, then the distribution can be taken without the 10% early distribution penalty, although, income tax would still be due.

The IRS, under certain circumstances, provide several exceptions to the additional 10% tax on early IRA distributions.  The intent behind these exceptions is that there are certain special situations that require some leniency in terms of applying the penalty.  Below is a summary of the details involved in satisfying the exceptions to the additional 10% tax apply for early distributions:

• The IRA holder is over the age of 59 1/2
  
• An IRA distribution made to a beneficiary or estate on account of the IRA owner’s death
  
• An IRA distribution made on account of disability. One is considered disabled if he/she can furnish proof that they cannot do any substantial gainful activity because of their physical or mental condition. A physician must determine that the condition can be expected to result in death or to be of long, continued, and indefinite duration
  
• Substantial equal periodic payments: An IRA distribution made as part of a series of substantially equal periodic payments for the IRA holder’s life (or life expectancy) or the joint lives (or joint life expectancies) of the IRA holder and his/her designated beneficiary pursuant to Internal Revenue Code Section 72(t). One must use an IRS-approved distribution method and must take at least one distribution annually for this exception to apply.
  
• An IRA distribution for a “qualified first-time home buyer.” Qualified first-time home buyer IRA distributions cannot be more than $10,000. To qualify for treatment as a first-time home buyer distribution, the distribution must meet all the following requirements:
  • It must be used to pay qualified acquisition costs before the close of the 120th day after the day the distribution was received. Qualified acquisition costs include the following items:
    • Costs of buying, building, or rebuilding a home.
    • Any usual or reasonable settlement, financing, or
    • other closing costs
  • It must be used to pay qualified acquisition costs for the main home of a first-time home buyer who is any of the following.
    • The IRA holder.
    • IRA holder’s spouse.
    • IRA holder or spouse’s child.
    • IRA holder or spouse’s grandchild.
    • IRA holder or spouse’s parent or other ancestor.
      
  • When added to all prior qualified first-time home buyer distributions, if any, total qualifying distributions cannot be more than $10,000. However, If both the IRA holder and his/her spouse are first-­time home­ buyers each spouse can receive distributions up to $10,000 for a first home without  having to pay the 10% additional tax. The IRS considers one a first-time home buyer if the individual had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy. 

• Health Insurance Premiums: An IRA distribution not in excess of certain medical insurance premiums paid while unemployed. The 10% early IRA distribution tax will not apply if all of the following conditions apply:
  • The IRA holder lost his/her job.
  • The IRA holder received unemployment compensation paid under any federal or state law for 12 consecutive weeks because they lost their job.
  • The IRA holder receives the distributions during either the year of the unemployment compensation or the following year.
  • The IRA holder receives the distributions no later than 60 days after they have been re-employed.
    
• Unreimbursed Medical Expenses. An IRA distribution for unreimbursed medical expenses: Even if one is under the age of 591/2, one does not have to pay the 10% additional tax on IRA distributions that are not more than:
  • The amount paid for unreimbursed medical expenses during the year of the distribution, minus 10% (or 7.5% if the IRA holder or his/her spouse was born before January 2, 1952) of the adjusted gross income for the year of the distribution. In general, one can only take into account unreimbursed medical expenses that one would be able to include in figuring a deduction for medical expenses on Schedule A (Form 1040). However, one does not have to itemize deductions to take advantage of this exception to the 10% additional tax. Note, the health insurance premiums while unemployed exception to the 10% early distribution tax does not apply to 401(k) qualified retirement plans.
    
• An IRA distribution due to an IRS levy, or
  
• An IRA distribution for a qualified reservist.

Qualified Higher Education Costs

Under this hardship exception, one is able to take money out of their Roth IRA to pay for “Qualified Higher Education Costs,” which are defined as tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.

For purposes of taking a hardship distribution for Qualified Higher Education Expenses, an eligible educational institution includes virtually all accredited, public, nonprofit, post-secondary institutions.  In other words, an eligible education institution does not cover elementary, middle, or high school expenses.  Qualified expenses are amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution. Eligible expenses also include student activity fees you are required to pay to enroll or attend the school.

The education must be for the IRA holder, his or her spouse, or the children or grandchildren of the IRA holder or his/her spouse.

Expenses NOT Treated as Qualified Higher Education Costs.

Even if you pay the following expenses to enroll or attend the school, the following are not treated as Qualified Education Expenses for purposes of the hardship exception:

• Room and board
• Insurance
• Medical expenses (including student health fees)
• Transportation
• Similar personal, living or family expenses

Note, the qualified higher education cost exception to the 10% early distribution tax does not apply to 401(k) qualified retirement plans.

Pros & Cons of Taking a Roth IRA Hardship Distribution

The key to taking advantage of the Roth IRA is to preserve and grow the plan.  For example, if one contributes $5,000 a year from age 28-72, assuming a 10% annual rate of return, at age 72 the Roth IRA would be worth approximately $3.5 million versus just $1.4 million if the income was subject to a 30% tax. 

Hence, when one pulls money out of a Roth to pay for college, or other hardships, those funds will no longer be working for you.  That is why it makes more sense to save for college via a 529 or Coverdell plan, where the funds are specifically earmarked for education and must be used for such.

Conclusion

The Roth IRA is probably the most powerful legal tax shelter.  Using a Roth to grow your retirement assets and generate tax-free income and gains is why so many Americans have turned to it as their key savings vehicle.  In certain circumstances, the IRS does allow for hardship distributions, such as to pay for Qualified Education Costs.

The hardship distribution exception allows a Roth IRA owner to take a non-qualified distribution and escape the 10% early distribution penalty and just pay income tax on the amount taken.  Once you satisfy the qualification rules, you’ll have tax- and penalty-free access to those funds to use however you wish.