<b>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 takinga 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. 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. There are, however, a few workarounds. If the family does not qualify for need-based financial aid, then the only consideration is the potential tax liability. This may make a Roth IRA an attractive vehicle for college savings, since the return of contributions is tax-free. The money in a Roth IRA can be used for retirement if the child does not go to college or if there are excess funds in the Roth IRA account. However, most families have a tendency to underestimate their eligibility for need-based financial aid, so this approach should be used with caution. If the family takes a distribution from their retirement plans in the student's last year in college after filing the FAFSA, or after graduation, there may be no impact on eligibility for need-based financial aid. Depending on the timing, the family may be able to avoid the 10% tax penalty. The student might use the distribution to pay off his or her loans. If the distribution consists entirely of a return of contributions from a Roth IRA, it can also avoid any tax liability. However, the parents need to be careful about the timing of the distribution if they have another child who will be enrolling in college. Retirement plan distributions might affect the student's eligibility for financial aid for graduate or professional school if the student enrolls immediately after graduating from undergraduate school. Distributions from the student's own retirement plans during the senior year will be treated as income on the subsequent year's FAFSA. Similarly, distributions from a parent's retirement plan that are used to pay for college costs may be treated as untaxed income to the student on the subsequent year's FAFSA since graduate students are automatically independent. While cash support from a parent to a dependent student is ignored on the FAFSA, cash support from a parent to an independent student is treated as untaxed income to the student. See Retirement Plans and Saving for College on the FinAid site for additional details.
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