Can 401k be Used for College?
Are you thinking about using your 401(k) for your child’s college education? Let’s find out the options you have, and what you can and can’t do with your 401(k).
The cost of college in the United States has gradually risen in recent years, with tuition and boarding taking a huge chunk of this cost. According to the National Center for Education Statistics, the cost of college is estimated to be $18,383 in public institutions, and it can go up to $47,419 in private institutions. While most students receive student loans and grants, these funds are never enough and students are forced to look elsewhere to get additional funds to pay for tuition and boarding expenses. A 401(k) is one of the sources that you can tap into.
If you are looking for a way to pay for college education, you can use your 401(k) savings to cover the cost of college. You can opt to withdraw money from your 401(k) or take a 401(k) loan. If you decide to withdraw from your 401(k) account, you can take a hardship withdrawal if you are below 59 ½. However, you will be required to pay income taxes at your tax bracket, in addition to a 10% penalty tax for early withdrawals if you are below age 59 ½. You can also borrow from a 401(k) up to a maximum of $50,000 or 50% of your retirement savings. With a 401(k) loan, you won’t pay taxes or penalties on the amount you borrow, unless you default.
Can You Withdraw Money from a 401(k) to Pay for College?
If your financial aid is not enough to cover your college expenses, you may consider withdrawing funds from your 401(k) plan. However, you should first check the 401(k) plan’s policy to know the employer’s rules for making withdrawals. Some employers limit withdrawals from the 401(k), and you may be required to prove a hardship for the withdrawal to be approved. You can take a hardship withdrawal to pay tuition, boarding, and other expenses for a child, spouse, or other dependent who is due to join college in 12 months.
401(k) plans have specific requirements that participants must meet to qualify for a hardship withdrawal. One of these requirements is that you must prove an "immediate and heavy financial need". You must provide documentation that proves that the expense you want to pay is an immediate expense that you are unable to pay from other sources. The plan administrator will assess other assets that you have such as investment accounts, savings accounts, and physical assets to determine if you can pay the expense by liquidating one of your assets.
If the hardship withdrawal is approved, the money will be reported as an income to the IRS, and you will owe income tax on the money. You may also be required to pay a 10% penalty tax for early withdrawal if you are below 59 ½. After taking a hardship withdrawal, some 401(k) plans limit employee’s contributions, and you may be forced to wait as long as 6 months to resume making contributions.
Can you Take a 401(k) Loan to Pay for College?
An alternative to a hardship withdrawal is a 401(k) loan, which allows you to borrow against your retirement savings to pay education expenses. In this case, you become the lender, and you will be required to make periodic payments back to your 401(k) account. The interest you pay helps grow your retirement savings. You can borrow up to 50% of your 401(k) account balance, with a maximum limit of $50,000. However, the plan administrator may limit the amount to less than what the IRS allows.
Usually, 401(k) loans allow a repayment period of up to 5 years depending on the amount you borrow. Any unpaid balance at the end of the repayment period is considered an early withdrawal, and you will owe income taxes on the outstanding loan balance. Also, if you quit or leave your job with an unpaid 401(k) loan, you will have until the next tax due date to pay off the outstanding balance.
Is it a Good Idea to Pay for College Using a 401(k)?
Using 401(k) to pay for college is a bad idea, and you should not use your retirement money to pay for your child's college expenses unless it is absolutely necessary. Before taking money out of your 401(k) account prematurely, you should exhaust all other funding alternatives available. There are tons of loans, grants, and short-term funding options for college students. If these funding sources are insufficient, you should discuss your financial situation with the college to see if there is a viable alternative.
If you dip into your 401(k) to pay for college, you are jeopardizing your retirement, and your retirement savings might run out when you need them most. The money taken out of a 401(k) is lost in taxes and penalties, and this results in lost investment growth. Your child has an entire life to pay off their student loan, and tapping into your 401(k) to fund their college expenses may haunt you in old age. Since you have a few years in active employment, you should protect your financial future by allowing the retirement savings to grow tax-deferred so that you will have enough to meet your expenses in retirement.