Pros and Cons of Using Retirement Funds to Pay for College Costs
October 03, 2011
A distribution from a retirement plan may affect eligibility for need-based student financial aid.
Money in retirement plans is ignored as an asset on the Free Application for Federal Student Aid (FAFSA). This compares favorably with the treatment of 529 college savings plans on the FAFSA. In the case of a dependent student, the 529 plan is treated as though it were a parent asset on the FAFSA, reducing aid eligibility by up to 5.64% of the asset value. In the case of an independent student, the 529 plan will reduce aid eligibility by up to 20% of the asset value.
However, distributions from a retirement plan will be treated as income to the beneficiary on the FAFSA. (In general, distributions from assets that are not reported as assets on the FAFSA are treated as income to the beneficiary on the subsequent year’s FAFSA.) Taxable distributions will be included in adjusted gross income (AGI). Tax-free distributions, including a return of contributions from a Roth IRA, will be reported as untaxed income on the FAFSA. If the student is the beneficiary, this can reduce need-based aid eligibility by up to 50% of the amount of the distribution. If the parent is the beneficiary, this can reduce need-based aid eligibility by up to 47% of the amount of the distribution. If the FAFSA is filed after the distribution but before the family pays the college bills, the money will be counted as an asset on the FAFSA.
The treatment of a retirement plan distribution as income has a much more severe impact on eligibility for need-based financial aid than the treatment of 529 plan funds as an asset. Distributions from retirement plans often eliminate eligibility for need-based financial aid entirely.
Most college financial aid administrators will not make adjustments to exclude retirement plan distributions from income, even if the family was forced to take a hardship distribution for living expenses after unemployment benefits ran out.
The proceeds from a 401(k) loan do not count as income on the FAFSA. However, depending on the timing of the distribution, the proceeds might count as an asset. The FAFSA does not offset assets by the amount of any unsecured loans. A 401(k) loan is considered an unsecured loan.
Families may ultimately net very little money from a retirement plan distribution after taking the tax liability and the reduction in aid eligibility into account.
Distributions from a retirement plan may not be used to qualify for the Hope Scholarship tax credit or Lifetime Learning tax credit. The IRS does not allow taxpayers to receive two tax benefits for the same higher education expenses.
There are limited opportunities to contribute to a retirement plan.
Most parents of college-age children are in their 40s and 50s, leaving them with little time before retirement age to make up the difference. Borrowing against a retirement plan or taking a distribution for college costs will effectively delay retirement by 5 years or more.
Contributions to retirement plans are also limited, making it difficult to catch up. In 2011, for example, there’s a $5,000 limit on contributions to an IRA ($6,000 for taxpayers age 50 and above) and a $16,500 limit on contributions to a 401(k), 403(b) or Section 457 plan ($22,000 for taxpayers age 50 and above). In constrast, contributions to a 529 college savings plan have higher limits based on the annual gift tax exclusion ($13,000 per parent in 2011).
There is no way to return contributions to a retirement plan after taking a distribution to pay for college costs.