All parents want to put their children in the best possible position to succeed – and securing a college degree is typically part of that process. Studies show that workers with a bachelor’s degree typically earn far more than their non-degreed counterparts – about 75-percent more over the course of a lifetime. They are also far less likely to experience prolonged bouts of unemployment.
Helping your child secure a valuable college degree may provide little solace, however, if it leaves you scraping by in your retirement years. Skyrocketing student loan debt, and the rising costs of higher education in general, are both spurring more parents to use their retirement nest egg to finance their children’s college education. A Sallie Mae survey of parents found that seven-percent are using retirement funds to pay for a child’s higher education – a figure that’s up from previous years.
Finance experts say parents should be aware of the long-term financial impact of such a move. Pulling money early from retirement funds can expose account holders to penalties, taxes and the possibility of making it more difficult to recoup money spent.
The consensus among most economists is to avoid raiding retirement funds to pay for college. Unfortunately, that’s not always possible. With that in mind, let’s review some of the most important information to know regarding retirement-funded college educations.
The Drawbacks of Early 401(K) Withdrawals
Most experts agree that taking a hardship withdrawal from your 401(k) is the worst option available. If you’re under 59 and a half, you’ll face a 10-percent penalty – in addition to owing taxes on your withdrawal.
Additionally, you may not be able to contribute to your 401(k) for at least six months. That means you’ll lose out on employer matches and accruing interest.
Using an IRA
Early Individual Retirement Account (IRA) withdrawals used to fund college aren't penalized like hardship withdrawals from 401(k) accounts. They can also be used for everything from tuition to books to room and board – but you'll still face taxes on any amount withdrawn.
Additionally, an IRA withdrawal may reduce your child’s eligibility for some financial aid programs, so it's important to review the situation closely.
Borrowing From a 401k
Taking out a 401(k) loan against your account is another option. It offers a significant advantage: if the loan is paid back within five years with interest, there are no taxes and penalties due. The downside is the payments are often steep, as they must be paid back in five years.
Generally, most 401(k) plans allow as much as $50,000 to be taken as a loan. If the monthly payments can be met, this could represent a safe option. Yet if the loan is not paid back in five years, or you switch jobs, you’ll be subject to taxes and penalties.
The Bottom Line
If you avoid paying taxes and penalties, by borrowing against your plan or using an IRA, it may seem like there are few drawbacks for the borrower. Yet financial experts say that’s not entirely correct.
Those who choose these options are still not making money on the cash withdrawn from their account. Economists call this “opportunity cost.”
When considering tapping your retirement funds for college payments, it’s also important to remember that student loans are often tax-deductible and typically viewed as “good debt,” by experts.
While financing a child’s college education through a retirement account is rarely anyone’s first choice, it’s possible to minimize the financial fallout by incorporating the information listed above.
