Pros and Cons of Using Retirement Funds to Pay for College Costs
October 03, 2011
Why should one NOT use retirement funds to pay for a child’s college costs? — Diane H.
There are two main reasons why families shouldn’t use retirement plan funds to pay for college. The first reason is the financial impact of taking a distribution from a retirement plan to pay for college. The financial impact includes both the tax liability and the reduction in eligibility for need-based financial aid. The second reason is that there are limited opportunities to save for retirement.
According to Sallie Mae’s survey, How America Pays for College 2011, 4% of families withdrew funds from their retirement plans in 2010-11, with an average distribution of $4,102. This compares with 6% ($8,554) in 2009-10 and 3% ($5,318) in 2008-09. About 1% of families borrowed an average of $2,779 from their retirement plans in 2010-11, compared with 3% ($6,901) in 2009-10 and 1% ($5,471) in 2008-09.
A distribution from a retirement plan may result in a tax liability.
If a taxpayer takes an early distribution from a 401(k) the taxpayer will pay a 10% tax penalty in addition to ordinary income taxes on the distribution. An early distribution occurs if the taxpayer is under age 59 1/2 or has not held the account for at least five years.
There is no 10% tax penalty for distributions from an IRA to pay for qualified higher education expenses, but a taxpayer may still have to pay income taxes on the distribution if the taxpayer are under age 59 1/2 or have not held the account for at least five years. With a traditional IRA the income taxes are based on the full amount of the distribution. With a Roth IRA the income taxes are based only on the portion of the distribution that comes from investment earnings. The return of contributions from a Roth IRA is tax free, regardless of when the distribution occurs, since the investment was made with after-tax money. Note, however, that the distribution cannot exceed the current year’s qualified higher education expenses, or there will be penalties charged on the excess distribution.
(Qualified higher education expenses include tuition and required fees, textbooks and, if the student is enrolled at least half-time, room and board. The distribution may be used for higher education expenses for the taxpayer or the taxpayer’s spouse, children or grandchildren.)
It is possible to roll a 401(k) retirement plan into an IRA in certain circumstances. This will avoid the 10% tax penalty on early distributions from a 401(k).
The tax liability can be avoided by limiting the distribution to a return of contributions to a Roth IRA or by taking a loan against a 401(k).
Borrowing from a 401(k) is a bad idea because the loan must be repaid in 5 years. If the taxpayer quits his or her job or is laid off or fired, he or she may be required to repay the loan in full immediately. (This may prevent people who are going back from school after being laid off from taking a 401(k) loan to pay for college costs.) If the taxpayer borrowers from his or her retirement plan, he or she will not be able to contribute to the retirement plan until the loan has been repaid in full. This means the taxpayer will miss out on the employer match, if any, for up to 5 years. While the taxpayer will effectively be paying the interest on the loan to himself or herself, this merely replaces the money the taxpayer would have earned if he or she hadn’t taken the loan. A better option is to borrow from the federal education loan programs, such as the Stafford student loan or the Parent PLUS loan, since these loans are better designed for postsecondary education needs.
The tax treatment of 529 college savings plans is more favorable when distributions are made to pay for qualified higher education expenses. Contributions to a 529 plan are made with after-tax money and earnings are tax deferred, like a Roth IRA. Qualified distributions from a 529 plan are entirely tax-free. But 529 plans have an added benefit, in that 34 states and the District of Columbia provide a state income tax deduction or tax credit on contributions to the state’s 529 plan.