Edward Fronczkowski, CPA, Partner
A question we often hear from parents is if they should use funds in their 401(k) to pay for their children’s college tuition. The short answer is you can, but just because you can does not mean you should. To put it simply, your 401(k) plan should be used for your retirement.
There are two primary reasons why you should not use your 401(k) for college funding. First, withdrawals from a traditional 401(k) are subject to tax in the year you make the withdrawal and if you have not yet reached the age of 59½, you will owe a 10% premature distribution penalty on the withdrawal! Second, taking money from your 401(k) will reduce the amount of invested money you have available to reap the benefits of compounding and tax deferral. This reduces the overall funds for your retirement.
Another option that you can consider is to borrow from your 401(k) plan. Some plans allow loans while others do not. On the surface, this sounds like a better idea as people think “I can pay myself back instead of paying back a bank”. But there are other considerations to think about.
Most 401(k) loans must be repaid within five years and generally you can only have one loan outstanding at a time. So, the loan you take out this year would have to cover four years of costs (up to a maximum of $50,000 or half the account value, whichever is lower). Since you must pay the loan off in five years, the savings would be minimal compared to paying the tuition over each of the four year period. If you can afford the monthly payments over a five-year period, you can probably afford to make annual payments over a four-year period and may not need to borrow at all.
Something that most people do not take into consideration is what happens if you separate from your employer and you have an outstanding loan. The full amount of the loan becomes due. If not paid in full, the loan is converted to a distribution, and taxes and penalty will apply as noted above.
Lastly, the benefit of a traditional 401(k) is that you are setting aside money on a pre-tax basis. If you take a loan, you pay yourself back interest using after-tax money. This means that withdrawals from your account in retirement will be taxed to you a second time! Most of us do not enjoy paying taxes and we certainly do not want to pay them twice!
There are a variety of other ways to manage costs without tapping into your 401(k). Be sure to explore all options such as financial aid, scholarships and student or parent loans before dipping into your retirement funds. If you still want to save for college in a retirement vehicle, consider using a traditional IRA or Roth IRA instead. With IRAs, if the money is used to pay your child’s qualified college expenses, you will not owe a 10% premature distribution penalty on withdrawals you make before age 59½.
If you have any questions, please contact your Maillie representative via phone or email.