You’ve saved a nice sum in a college savings plan over the years, but not enough to cover the full cost of the schools your teen is considering. How will you fill the gap? Your mind goes to possible resources: financial aid, income, and your own savings, including 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 distributions from a company plan, such as a 401(k), to pay for higher education will be subject to a 10% penalty in addition to the regular income tax levied on all distributions.
An exception exists for early distributions from IRAs. These are 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 and affect financial aid calculations the following year.
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 59 ½. But be sure to understand the Roth IRA rules since all withdrawals are not automatically tax free. Visit finaid.org and irs.gov to understand Roth IRA holding periods and taxation.
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 is not without risk. 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 the loan may be considered income. It will be subject to income tax and, if you are younger than 55, a 10% penalty. Check the loan rules carefully.
YOU MISS OUT ON GROWTH
Withdrawing or borrowing from a retirement account to fund college causes you to miss out on growing those assets. Before resorting to a withdrawal, carefully consider the impact on your retirement plans.
Keeping your retirement savings invested and growing tax-deferred can be very powerful in helping you reach your retirement savings goals.
OTHER OPTIONS
Encourage your child to apply to schools for which their grades and test scores put them in the top of the applicant pool. This will increase their chances for merit aid which does not need to be repaid.
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 payments.
If you still find you are falling short of fully funding college, consider taking advantage of federal loans or a home equity loan, rather than using your accumulated retirement savings. While taking on debt is not ideal, you won’t deplete your retirement savings and sacrifice the quality of your twilight years.
If you need help determining how much you can really afford to pay for your child’s education, contact us. We help our clients ascertain the amount of education costs that fit into their family’s long-term financial plan.