Congratulations! Your child got into college! Now comes the really challenging part … paying for it!
You may have saved a nice sum in a college savings plan over the years, but not enough to cover the full cost of the school your teen is considering. How will you fill the gap? As your mind goes through the possible resources – financial aid, current income, and your own savings – you then consider your retirement savings. Does it make sense to liquidate or borrow from your own retirement savings to pay for college?
UNDERSTAND PENALTIES AND IMPLICATIONS OF EARLY WITHDRAWALS
Penalties and taxes generally make withdrawals from retirement savings a poor option to pay for college.
Early withdrawals from employer-sponsored retirement plans like 401(k)s for higher education expenses will incur a 10% early withdrawal penalty on top of regular income taxes if the plan holder is under age 59½. Education costs do not qualify as an exception to the 10% penalty for early distributions from company retirement plans, unlike certain other hardship circumstances.
An exception exists for early distributions from IRAs. These remain penalty-free when used to pay for qualified higher education expenses. However, the taxable portion of IRA withdrawals is subject to income tax, and the full withdrawal will count as income which could significantly affect financial aid calculations the following year under current FAFSA rules.
A Roth IRA withdrawal may be a better option, as withdrawals for higher education are penalty-free and withdrawals of contributions are tax-free even for those under 59½. However, be sure to understand the Roth IRA rules since not all withdrawals are automatically tax-free, particularly for earnings. Visit finaid.org and irs.gov to understand Roth IRA holding periods, taxation and financial aid rules.
BORROWING FROM RETIREMENT ACCOUNTS CAN BE RISKY
Depending on your employer’s retirement plan rules, you may be able to take a loan against your account value to help pay for college. However, this strategy remains risky. If you change jobs, you may have to repay the loan immediately. If you are unable to repay the loan, it will count as a distribution and may be considered taxable income. It will be subject to income tax and, if you are younger than 59½, a 10% penalty (unless you are 55 or over and qualify for the “rule of 55“). Check the loan rules carefully with your plan administrator before choosing this option.
YOU MISS OUT ON GROWTH
Withdrawing or borrowing from a retirement account to fund college causes you to miss out on growing those assets during crucial earning years. Before resorting to a withdrawal, carefully consider the impact on your retirement plans, especially given increased life expectancies and rising healthcare costs in retirement.
Keeping your retirement savings invested, with compounding tax-deferred growth can be very powerful in helping you reach your retirement savings goals.
OTHER OPTIONS TO CONSIDER FIRST
Merit Aid Strategy: Encourage your child to apply to schools where their grades and test scores put them in the top of the applicant pool. This increases chances for merit aid, which does not need to be repaid and has become increasingly important as need-based aid calculations have changed.
Expense Management: Can you decrease your living expenses and pay more tuition out of pocket? Explore available tuition payment plans to break the cost up into more affordable monthly payments.
Alternative Borrowing: If you still find you are falling short of fully funding college, consider federal student loans first (which have borrower protections), then potentially a home equity line of credit, rather than using accumulated retirement savings. While taking on debt is not ideal, you won’t deplete your retirement savings and sacrifice your future financial security.
529 Plan Strategies: Consider grandparent-owned 529 plans, which, under current FAFSA rules, no longer negatively impact financial aid calculations when distributions are taken.
Community College Start: Consider having your student begin at a community college to reduce overall costs while completing general education requirements.
NEW FAFSA CONSIDERATIONS FOR 2025
Regardless of which path you decide to take to fund your child’s college, it is always a good idea to complete a Federal Application for Federal Student Aid (FAFSA) in case you decide to utilize some of the above options. The FAFSA is the primary form that students and families must complete to apply for federal financial aid for college, and has recently undergone significant changes that affect how retirement withdrawals impact financial aid.
Key updates include:
- The Student Aid Index (SAI) has replaced the Expected Family Contribution (EFC) calculation.
- IRA and 401(k) withdrawals will still count as income and could reduce aid eligibility for the following year.
- Retirement account balances are still not reported as assets on FAFSA, but withdrawals must be reported as income.
- The number of family members in college no longer factors into the FAFSA calculation, potentially reducing aid for families with multiple students.
THE BOTTOM LINE
With longer life expectancies and rising healthcare costs, protecting your retirement savings has become even more critical. The tax implications and potential impact on financial aid make retirement account withdrawals a costly way to fund college. Explore all other options first.
If you need help determining how much you can really afford to pay for your child’s education while maintaining your retirement security, consider consulting with a financial advisor who can help you create a comprehensive strategy that balances college funding with your family’s long-term financial goals.