Retirement plans often allow you to withdraw money to help pay for a student’s college expenses. Parents routinely borrow money from their 401k or IRA to pay for tuition, fees, room and board. Using retirement funds to cover college costs is usually discouraged.
Here are some important topics for using a 401k or IRA to pay for college:
There are several advantages of taking out a 401k loan. When you pay back a 401k loan you are essentially paying yourself, and the interest you pay is eventually returned to you in the form of disbursements when you retire. Taking out the loan to pay for college expenses also has no impact on a student’s eligibility for need-based financial aid. Unlike withdrawing funds from an IRA, there is no 10% early withdrawal penalty and the funds are not subject to income tax.
There are two main drawbacks to a 401k loan. The first is that withdrawing funds reduces the long term productivity of your retirement account. The other is that if you quit your job or are terminated then the 401k loan must be paid back in full, usually within 60 days.
You can also withdraw money from your Roth IRA or your traditional IRA to cover college costs. When an IRA withdrawal is used to pay for qualified education expenses the money is exempt from the 10% early distribution penalty normally levied on withdrawals before age 59½. Withdrawals can be used for tuition and fees, as well as room and board or other supplies.
When you withdraw money from your IRA it may be subject to income tax. If you have a traditional IRA, the full amount of your withdrawal will be subject to income tax. However, with a Roth IRA your withdrawal is tax-free if it comes only from your contributions. Any portion that comes from earnings on your contributions will be subject to income tax if it is withdrawn before you reach age 59½. If you are over 59½ years of age, and you have had your Roth account for more than five years, your entire withdrawal is tax-free.
Parents can also use their Roth IRA as a tax-deferred college savings account. By limiting withdrawals to only their contributions they avoid paying income taxes. The earnings, which are not withdrawn, can remain in the account to help pay for retirement. The withdrawn funds are not only tax free but are also not subject to the 10% early withdrawal penalty if used for qualified higher education expenses.
There are some disadvantages to withdrawing money from your IRA to pay for a student’s college expenses. While having funds in a traditional IRA does not affect your student’s eligibility for need-based financial aid, withdrawing the funds counts as income and can therefore affect their eligibility for need-based financial aid during the next year.
Another disadvantage is that you are depleting your retirement savings. You can not simply redeposit funds back into an IRA once the money has been withdrawn. Deposits into an IRA are subject to the annual limits: $4,000 for 2007 and $5000 in 2008. It may take you several years to replenish the funds that you’ve withdrawn.
Borrowing from your 401k or withdrawing from an IRA to pay for college expenses should be considered only as a last resort. Parents should concentrate on saving for their retirement first. Encourage your student to apply for scholarships and financial aid. If you have several years before your student starts school then consider a 529 savings account.
Most 401k plans allow employees to borrow half the funds in their account up to $50,000. The money you borrow from your account is already yours, but your still have to pay it back with interest. The interest rate you pay is usually the prime rate plus one or two percentage points. A 401k loan must also be paid back over the course of 5 years.