Since many parents of college-aged children have been contributing to a 401(k) for many years, it can be tempting to use some of those funds to help pay for their child’s education. If you are considering using your 401(k) to pay for your child’s education, here’s what you need to know.
401(k) Loans vs. Withdrawals
Typically, if you want to use your 401(k) to fund your child’s education, you have two options: loans or withdrawals.
A 401(k) loan involves borrowing against your 401(k). Essentially, money from your retirement accounts is loaned to you for a specific period. Like any loan, you have to pay the funds back with interest. However, this means the money removal is temporary, not permanent.
Not every 401(k) plan allows loans against their value. This means you need to check in advance to see if this is an option. For those that do, the payments are usually spread out over multiple years. Interest rates can vary, so there is no guarantee that this approach is more affordable than a student loan. However, the interest you pay is put back into your 401(k).
Withdrawals permanently remove money from your 401(k) account. Typically, you can do this for educational expenses, including for your child’s college. But, it’s important to understand that there are consequences for these withdrawals.
First, if you are not at least 59 ½ years old, you’ll pay an IRS 10 percent early withdrawal penalty. Second, the money qualifies as income for that tax year, so you will likely see a higher federal tax bill, too.
Is It the Right Move?
Every person’s financial situation is different, so you need to examine a few key points to determine if using your 401(k) is a wise choice. If you’re considering a 401(k) loan, then compare the interest rate to student loan rates to see which is lower. This serves as a solid indication as to which is the financially smart choice.
However, if you plan on leaving your current job soon, a loan isn’t always best. If you don’t get the loan repaid before leaving your position, it can qualify as a withdrawal. This means you owe the penalty and have to count the remaining balance as taxable income.
Remember, for withdrawals, your age plays a factor. If you are over 59 ½, then you don’t pay the 10 percent penalty. This can make it a great option if you have enough retirement savings to sustain you. Otherwise, if you will pay the penalty, it could be the more expensive approach.
There is a way to avoid the 10 percent penalty if you really must use your 401(k) savings to fund your child’s education. However, not everyone can take part. If you leave the job where you had a 401(k), you can roll it into an IRA. IRAs don’t have the same penalties, so this could work if the opportunity to do a rollover arises.
Your Financial Future
One of the most responsible things you can do as a parent is solidify your financial future. Focus on your retirement savings if you don’t have enough to provide for a comfortable retirement yet. If you haven’t reached that point, then focus on your savings and consider investments outside of your 401(k) to pay for your child’s education.
While wanting to help your child is admirable, it shouldn’t be at the cost of your own financial future. Remember, the choices you make today could inadvertently affect you and your child in the future, so choose wisely.
Alternatives to Using Your 401(k)
Ultimately, there are other options than using funds from your 401(k). If you have stocks or CDs, consider cashing them out instead. If your child isn’t going to college for a number of years, open up a 529 College Savings Plan and start socking money away for their education now.
Good savings habits can go a long way when it comes to planning for your kid’s college expenses, and it’s never too late to start. So, start getting organized today. Your child will thank you for it.
For more of our great articles, read:
- The Future of Student Loans Under Donald Trump May Change
- IRS Announces 2018 Tax Rates
- Even if You’re Strapped for Cash, You Can Still Invest
Tamila McDonald has worked as a Financial Advisor for the military for past 13 years. She has taught Personal Financial classes on every subject from credit, to life insurance, as well as all other aspects of financial management. Mrs. McDonald is an AFCPE Accredited Financial Counselor and has helped her clients to meet their short-term and long-term financial goals.