When faced with looming college expenses, many parents quickly find out that they haven’t saved adequately. If you’re in this situation, it may be tempting to tap into your retirement savings to pay for your child’s college education, but this is seldom the best option. As a parent, you are probably accustomed to putting your child first. But by protecting your retirement savings, you actually are putting your child first. After all, if you haven’t saved adequately to pay for your expenses during retirement, you might need your children to help foot that bill, which could be even bigger than college costs. Here’s what happens if you use retirement accounts to pay for college.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
Look at the tax consequences. It’s important to understand the tax implications of using retirement funds to pay for your child’s college education. Tapping your 401(k) to fund education expenses will nearly always result in penalties. There is an early withdrawal penalty on distributions from your traditional 401(k) before age 59 1/2, and income tax is also due on the amount withdrawn. Alternatively, you could take out a 401(k) loan, which requires you to pay yourself back. But 401(k) loans charge fees, and if you fail to pay back the loan, you could face income tax and an early withdrawal penalty.
Another option is to tap into an IRA, which allows you to pay for qualifying education expenses for yourself, your spouse, your children or your grandchildren without incurring the early withdrawal penalty. However, you will still owe income tax on traditional IRA withdrawals.
Check the implications for financial aid. The money in a parent’s retirement account is not factored into financial aid calculations. This means that you could have hundreds of thousands of dollars stashed in a 401(k) or IRA, and that savings won’t hurt your child’s chances of obtaining need-based financial aid. However, if you take a withdrawal from your retirement account, that amount is considered income and will count against your child’s financial aid eligibility. So tapping your IRA for your child’s freshman year expenses could result in much lower aid eligibility. Before you decide to withdraw money from your retirement accounts to pay for college expenses, talk with a financial aid expert about how this will affect your child’s future aid package.
[Read: Fewer Families Use Retirement Accounts to Pay for College.]
Factor in compounding interest. Depending on your investment selections, your 401(k) rate of return might be higher than the interest rate you’re likely to be charged on student loans. If you’re getting an 8 percent return on your 401(k) portfolio, but your child’s student loans will only cost 6 percent interest, your family will come out ahead by keeping the money in the 401(k). And if your child qualifies for subsidized loans the government pays the interest while the student is in school at least half-time. In this case, leaving money in your retirement accounts is the better option, even if it means you commit to helping your child pay off student loans after college. Compounding interest is a powerful force, and you are likely to be better off over the long term if you leave the money to grow in your retirement accounts. You can always help your child pay off student loans later.
Consider other ways to pay for college. Your child can get help paying for college, but you can’t get help paying for retirement. Outside of Social Security and Medicare, you’re on your own when it comes to funding your retirement. But you can help your child take out student loans and find grants and scholarships to pay for school. Plus, you might be able to solicit help from grandparents and family friends to pay for college in lieu of giving your child gifts for holidays and birthdays. You probably won’t be able to crowdfund your retirement expenses.
[Read: How to Pay Less Taxes on Retirement Account Withdrawals.]
Look at how much money you stand to lose if you pull money from a retirement account. This isn’t just how much you withdraw immediately, but also the returns you will lose over time. Also, consider other sources of income you are eligible to tap for your child’s educational ventures before you decide whether or not you should use your retirement savings to pay for education costs.