Why should one NOT use retirement funds to pay for a child's
— 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
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
income tax deduction or tax credit on contributions to the state's 529
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
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
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
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
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
However, the parents need to be careful about the timing of the
distribution if they have another child who will be enrolling in
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.