Paying for College With Your 401k: Can You? Should You?

Paying for College With Your 401k: Can You? Should You?

Believe it or not, we’re already in “back to school” season.  And to continue our recent series of posts on paying for college, today’s covers a question I’m sure will resonate with many readers:

Should you raid your 401k to pay for your kids’ college?

There are a lot of moving parts to this question.  First, can you even get money out of your 401k to pay for college costs?  Are there early withdrawal penalties for doing so?  And aside from the logistics, is it even a good idea to?  This post will cover whether it’s possible…and whether you should.

 

Taking Money Out of Your 401k

Let’s start with the logistics of getting money out of your 401k in the first place.  Typically, most 401k plans require some type of “triggering event” (like separation of service) before they’ll let you to take money out of your 401k plan.  But rather than sticking the cash in their bank account, most people elect to deposit the funds in an IRA.  This is called an IRA rollover, since you “roll” the funds directly out of your 401k and into an IRA, preserving the tax advantages.

Some plans will allow what are called “in service withdrawals”, or “in service distributions”, which allow you take money out before such a triggering event.  The term “in service” meaning you’re still working at the company sponsoring the 401k plan.  Not every 401k plan allows in service withdrawals.  And those that do may impose some other limitations, like a minimum age (usually 59 1/5, to coincide with the tax rules), or a minimum tenure with the company.

If your plan doesn’t allow in service withdrawals, the only way you’ll be able to take money out of your 401k (assuming you’re still working there) is through a hardship withdrawal or a loan.  In a hardship withdrawal, you’d claim that you have an “immediate and heavy need” to access your assets.

Not every plan allows hardship withdrawals, either.  Those that do must adhere to the IRS definition of an acceptable “hardship”.  Fortunately, payment of college tuition and related costs for you, your spouse, dependents, or children are included in that definition.  The bad news?  Hardship withdrawals are subject to the 10% early withdrawal penalty.  Plus income taxes.

 

Loans

If your plan doesn’t allow for in service withdrawals (or you’re not eligible to take one), a loan is the other option to take money out of your 401k plan.  It can be costly, though.  Again, every plan is different, and yours may or may not allow loans at all.  Of plans that do, most will only let you take out one loan at a time, up to a max of $50,000.  That means that if you wanted to borrow from your 401k to pay for your kid’s college tuition, you’d need to take out enough initially to cover four years’ worth (or more) of costs.

Another drawback of taking loans against your 401k is that they must be paid back in 5 years.  And if you can afford to repay your 401k loan in five years, you can probably afford to pay the costs out of pocket in the first place.

Finally, all the contributions to your 401k are made on a pre-tax basis.  Then, when you begin withdrawals in retirement later on, ever dollar you take out is counted as taxable income.  If you borrow from your 401k along the way, the money used to repay the loan is on an after tax basis as well.  That means that in effect, you’d be taxed twice by taking out the loan.  First on the money to pay it back, and again when you withdraw from the plan in the future.

 

So What’s the Best Way to Take Money Out?

To summarize, hardship withdrawals could be an option if they’re offered in your plan.  However, you’d owe income tax and incur the 10% early withdrawal penalty by doing so.  A loan would bypass the early withdrawal penalty, but the tax implications would be….not good.

The best strategy, if it’s available to you, would be to take an in service withdrawal by rolling your assets into an IRA.  Whereas 401k plans don’t have an exception to the 10% early withdrawal penalty for qualified educational expenses, IRAs do (as do Roth IRAs).  It’ll still count as taxable income though.  And if you’re like most parents, your kids will be attending college during your peak earnings years.  Which means that taking a withdrawal won’t just mean adding to your taxable income.  It’ll mean adding to your taxable income at the highest rate you’ll ever pay.

 

So Is It a Good Idea to Pay for College with Your 401k?

In short – no, probably not.  And if the only way you can access the funds is to take a hardship withdrawal or a loan, it’s definitely not a good idea.  Hardship withdrawals will ding you with the 10% early withdrawal penalty, and loans will tax you twice eventually.

If you’re able to take an in service withdrawal into an IRA….it still probably doesn’t make sense.  But if you’re absolutely sure you don’t need the money to live a comfortable retirement, it might be OK.

Just remember that the best gift to your kids isn’t college tuition.  It’s your own, permanent financial independence.  Your kids will be able to borrow money to pay their tuition, if they want to.  College is actually the one expense we can borrow money for without any limit.  When you buy a car or a house, banks will only lend you a certain amount, based on your income and assets.  But when it comes to college there are no limitations.  There’s a limit to how much your kids should borrow, but that’s a good topic for another post.

So what happens if you dip into your 401k now, and run out of money when you turn 85?  You won’t be able to borrow money as easily then as your kids can now.  And I’m guessing that if you asked them, they’d rather borrow a little extra to pay for college now than have you needing their financial assistance 40 years down the road.

All in all, it probably doesn’t make sense to raid your 401k to help out with tuition costs.  Even if you can access the funds, most people will be better off using it for their own retirement.

Posted in Financial Planning, Paying for College, Student Loans and tagged , , , , , .

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