OK To Tap Your 401(k) For College Expenses?

OK To Tap Your 401(k) For College Expenses?

When it comes to their children, many parents take the view that supporting their kids is first priority.  That’s admirable from a family standpoint, but may not be optimal from a financial one.  And nowhere does this have bigger consequences than with college expenses.  A common question I encounter is whether or not it’s possible to withdraw funds from a 401(k) for your child’s college expenses.  In fact, you can use a 401(k) to pay for college.  But one of my favorite adages applies here:  Just because you can doesn’t mean you should.

There are generally two ways you can prematurely withdraw funds from a 401(k) for any purpose (including paying for college).  One is via a loan.  Although 401(k) plans are not required to allow loans, most do.  You are limited to 50% of your 401(k) balance or $50,000, whichever is smaller.  But there are a number of disadvantages with this approach:

  • Although you are paying yourself interest, the rate paid on a plan loan is often less than the rate the plan funds would have otherwise earned.
  • Contributions to a 401(k) are ordinarily tax-deductible. But the loan interest and principal repayments are not deductible.  Since they come from money that has already been taxed, you are being double-taxed on the total amount.
  • If you lose your job or change jobs, most plans require you to pay back the loan within 60 days of termination. If you fail to repay, the loan will be considered to be in default, which will result in taxation on the outstanding balance as well as a possible 10% early withdrawal penalty.
  • Money used from a retirement account for college expenses is treated as income to you from a financial aid standpoint. Therefore the financial aid you may be offered for the following year will likely decrease.

There is an alternative way to tap your 401(k) for college expenses, and that is to simply withdraw the money prematurely.  However, you will be taxed on the full withdrawal together with an additional 10% penalty.   And again it will negatively impact any financial aid to which you might be entitled.

You may find yourself in a financial situation where you feel you have no choice.  But I recommend considering a 401(k) (and any other retirement plan for that matter) to be the last resort for college funding.  If you apply for financial aid for college there are numerous sources of funding ranging from outright grants to loans at favorable rates to work/study programs to scholarships.  And although college debt should be carefully managed, at least it’s available.  There are no sources of funding available for your retirement expenses except for your own savings or welfare.

Which brings me to the last consideration: the impact of your own financial future on your children.  If you were to put them first, and sacrifice your retirement savings to pay for college for them, consider what would happen if you turn 70 or 80 and run out of money.  Are you going to move in with them or require their financial support in some other way?   By ensuring your own financial future is secure, you are helping your children by ensuring you do not become a burden on them later in your life.  That’s a pretty valuable gift!

We all want to do the right things for our children.  But putting your retirement at financial risk is not a good strategy.  Leave that 401(k) alone if you can.

 

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.