Have you considered using retirement funds to save or pay for college? Is that a good or bad idea? As is the case with many complex financial issues, it depends on someone’s individual circumstances.
For most Americans, college is expensive. Whether you attend a community college, a state university, or a private institution, finding the money for tuition and living expenses can challenge many households. While some families may have the funds to pay for college, others have to depend on loans or money earned while working.
As for the idea of using the money you’ve saved in a 401(k), Individual Retirement Account (IRA), or another type of tax-deferred savings plan, examining the pros and cons is a good idea. This article will examine the different retirement plans, whether it’s wise to dip in your retirement to pay for college, and whether it’s better to explore student loans.
A Review of Retirement Plans
Before we dive into the issue of whether using retirement dollars for college is a good choice, let’s quickly review the six types of retirement plans. Each plan has different stipulations, benefits, and requirements, so if you have detailed questions about any plan, we recommend you consult with a qualified financial adviser or tax expert.
401(k)
This plan is offered by many employers as a benefit to save for retirement. You can designate a portion of your pay to a tax-deferred account. You can also contribute up to $19,500 annually to a 401(k) plan. Some but not all employers match or contribute to 401(k) plans. Money can grow tax-free and is only taxed after it is withdrawn.
Individuals can begin to withdraw funds without a penalty at age 59 ½ and are required by law to begin withdrawing funds no later than 72. Keep in mind that if you withdraw funds before the minimum age, there is a 10% tax penalty, and the withdrawal amount is subject to state and federal income taxes. Variations of this type of plan include the 403(b) for education and nonprofit employees and the 457(b), which is available to government employees.
Individual Retirement Accounts (IRA)
Similar to 401(k)s, this account is available to individuals who don’t have access to company-sponsored retirement plans. Funds may be invested in equities, bonds, mutual funds, ETFs, or other types of investment vehicles.
You can contribute a maximum of $6,000 in 2020. For individuals aged 50 or older, though, that amount increases to $7,000. And like most retirement accounts, your money grows tax-free until withdrawn. Penalties and taxes may apply if withdrawn before 59 ½ years of age. Also, note that there are some restrictions based on income.
Roth IRA
This type of account is used for after-tax contributions, as opposed to pre-tax dollars. However, the gains in the account are not taxed if the account increases in value or when withdrawn. One advantage to this account is you can withdraw funds without penalty provided five years have passed since you contributed. You can also contribute to both a Roth IRA and traditional IRA, provided the total amount doesn’t exceed $6,000 annually.
Roth 401(k)
This type combines the benefits of a 401(k) and a Roth IRA. It’s new to the investment account lineup and is only available through employers. Instead of making pre-tax contributions, employees contribute after-tax dollars, which are never taxed again as long as the plan is kept in place for a minimum of five years.
SIMPLE IRA
Known as the Savings Incentive Match Plan for Employees plan, this type of IRA is designed for small businesses with 100 or fewer employees. It works much like a traditional IRA, with the major difference being you cannot borrow from this IRA like you can from a traditional one.
SEP IRA
This type of retirement plan is designed for self-employed individuals and is called a Simplified Employee Pension plan. One benefit is that contributions are fully deductible from your taxable income. Also, contribution limits are much higher since you can contribute $57,000 or 25% of your income, whichever is less.
Can I Use My Retirement Savings for College Expenses?
For most types of retirement accounts, the answer is yes. However, be aware of the stipulations, risks, and penalties for each type of account. For example, if funds are withdrawn early, there could be penalties and taxes. Yet, there is a more pertinent question to ask:
Is It Wise to Use Retirement Savings for College Expenses?
Most financial professionals recommend against using or borrowing from retirement accounts to pay for college expenses before other options are explored.
First, there are accounts specifically designed to save for educational needs, and each offers unique tax benefits. Coverdell Education Savings Accounts (ESAs) and 529 College Savings Plans allow money to grow tax-free. The primary benefit of these accounts is that any money used to pay for expenses like tuition, fees, and room and board are not taxed. States that offer 529 plans also throw in some additional benefits, so check with the agency or department that oversees these plans in your state for the complete details.
Although funds withdrawn from any traditional IRA or Roth IRA retirement account to pay for college prior to age 59 ½ are typically exempt from the 10% early withdrawal penalty, the amount withdrawn is taxed based on your taxable income. Keep in mind that colleges usually count distributions from IRAs to pay college expenses as income. This could impact your ability to borrow or qualify for some student loans.
Can I Borrow Money From My Retirement Account for College Expenses?
Depending on the type of plan, it is possible to borrow from a retirement account without penalty to pay for college expenses for your immediate family and even your grandchildren, but there are risks. Here are a couple of things to consider:
- You must prove you or a family member is enrolled and attending an approved institution
- The amount you withdraw cannot be greater than the expenses incurred for college
Employees who lose or change jobs with an outstanding loan balance from a retirement account may be required to pay back the amount immediately and with interest. For those younger than 55 and unable to pay back the entire balance, the outstanding amount will be treated as taxable income and subject to the 10% withdrawal penalty. For those 55 or older, the early withdrawal penalty would not apply, but the loan balance would still be treated as ordinary income.
When in doubt on how the impact of a higher tax bracket will impact your and your family’s finances, it’s best to consult a qualified accountant or tax expert.
Other Options
There are many options to consider that can help pay for college expenses before tapping into a retirement plan. You may want to consider:
- Regular savings accounts
- Earned income
- Grants or scholarships
- Work-study programs
Should I Explore Student Loans?
If funds are needed to pay for college expenses, and you don’t have all the cash required, there are various types of student loans available.
Depending on your individual or family financial situation, obtaining some type of student loan is more advantageous than pulling funds from a retirement account since interest rates on student loans are relatively low compared to the penalties and taxes associated with retirement account withdrawals.
We Are Here for You
When considering how to pay for college or obtain a student loan, we invite you to explore the many options available at College Finance. We can help you understand the many ways to pay for college. There’s no better place than College Finance when it comes to planning, borrowing, and repayment. We want you to get the most out of your college investment.
