Paying for Education with Your 401k. Good or Bad Idea?
Why not borrow from my
401(k) for my daughter’s college tuition, as there will be less to lose in this
economic crisis? -- Betsy Thomas
Mark Kantrowitz Says:
Borrowing from your 401(k)
is almost always a big mistake. It may seem innocuous, since instead of paying
back a bank loan, you're paying yourself. But you've lost the opportunity to
earn further returns on the investments in your retirement plan. Borrowing from
your 401(k) locks in losses on your investments and will likely miss out on any
possible recovery in the stock markets. After investors overreact to bad news
with panic selling, there is typically a big jump in the overall stock market
followed by a lot of volatility and a more gradual slow recovery stretched out
over several years. Making regular periodic investments in your retirement plan
account gives you the benefit of dollar-cost averaging, which works best in
such a volatile and uneven stock market. But when you borrow from your 401(k)
your monthly payments go toward repaying the debt, not further investment, so
your retirement plan account will fall further behind your goals. You will also
miss out on your employer's matching contributions. A 401(k) also converts the
pretax dollars in the retirement plan into after-tax dollars, since the loan
payments are made with after-tax dollars.
You also need to consider
the possibility that the economic crisis may put your job at risk. If you
happen to lose your job because of the economy you will have to repay the loan
immediately if you haven't reached age 59 1/2. If you are unable to repay the
debt -- after all, you just lost your job -- you'll have to pay taxes on the
"deemed" income plus a 10% tax penalty.
Federal education loans are
usually a better deal than borrowing from your 401(k). The unsubsidized Federal
Stafford and Federal PLUS loans are fixed rate loans, with interest rates of
6.8% and 8.5%. (The interest rate on the subsidized Stafford
loan is lower for undergraduate students, due to a phased-in interest rate
reduction. The interest rate on the PLUS loan is 7.9% at colleges that
participate in the Direct Loan program.) The interest rate on 401(k) loans is a
variable rate, typically Prime + 1% or Prime + 2%. Up to $2,500 per year in
interest on federal education loans is tax deductible (as an above-the-line
exclusion from income, even if you don't itemize) while interest paid on a
401(k) loan is not tax deductible. The loan term on a 401(k) loan is up to 5
years, while federal education loans start off with a 10 year term that may be
extendable to as much as 30 years in certain circumstances. The loan limit on
the PLUS loan is up to the full cost of attendance, while a 401(k) loan is limited
to half the retirement savings or $50,000, whichever is less.
Under no circumstances
should you take a distribution from your IRA or a hardship withdrawal from your
401(k) to pay for higher education expenses. While this may avoid the 10% tax
penalty, it will count as income and affect student aid eligibility in the next
year. Your net after taxes and the financial aid reductions will likely be less
than 40 cents on the dollar and perhaps much lower.
