When Should You Consider Using Your 401(k) for Educational Expenses
Using your 401(k) to cover college expenses may seem convenient, but it’s crucial to make an informed decision. Tapping into your retirement account and making an early withdrawal can have long-term implications for your own retirement readiness and retirement income down the line, not to mention a costly near-term tax bill.
Because you made tax-deferred contributions to your pre-tax 401(k), you’ll need to pay income taxes on withdrawals, and, depending on how much you withdraw, taking money out can be quite costly. You may qualify for a hardship withdrawal when you take funds out to pay for qualified education expenses, but you’ll still be facing a meaningful IRS bill.
Keep in mind that 401(k) withdrawals for educational expenses do not qualify for an early withdrawal penalty waiver, which means you’ll be on the hook for another 10% penalty tax in addition to income tax.
Before cashing out your 401(k) to pay for college expenses, weigh the potential benefits against the long-term negative impact to your retirement income. Tapping your 401(k) may be an appropriate choice only when you have exhausted all other options. It’s a good idea to chat with a financial professional.
Rules and Regulations for Using a 401(k) for Educational Expenses
If you decide to use your employer-sponsored 401(k) for educational purposes, be aware of the rules and regulations that govern these early withdrawals, which are not penalty-free:
- Typically, you’ll pay 10% early withdrawal penalty fees for distributions made before age 59 ½.
- Since the money was invested tax-deferred, you’ll need to pay federal income tax on the withdrawn amount, and state taxes may also apply depending on your location. Typically a withdrawal counts towards your taxable income for the year, which could push you into a higher tax bracket.
Another factor to consider is that financial aid, including federal student aid, is based on your Adjusted Gross Income (AGI). Withdrawing funds for higher education costs will boost your AGI for the year, potentially reducing your financial aid eligibility.
Steps to Withdraw from Your 401(k) for Educational Expenses
To withdraw retirement funds from your 401(k) for educational expenses, you can follow these general steps:
- Contact your plan administrator to discuss your intentions and to learn about procedures or withdrawal rules specific to your plan.
- Once you understand the process and implications, if you move forward with the withdrawal, you’ll be asked to complete the necessary paperwork to unlock your retirement funds.
- Once everything is in order, the timeline for receiving funds will vary, so plan accordingly to ensure the funds are available when needed.
Because of the variability of the timeline, it’s smart to get this process underway in advance so you can avoid any gaps in funding needs or situations where you fail to meet lender requirements.
Loans, Repayment and Retirement Savings
So far, we have been discussing the option to take an early distribution from your 401(k). But you an also loan yourself money from your 401(k) retirement savings plan, which can help you avoid the early distribution penalty fees, on the condition that you make timely payments (with interest) back to your retirement plan.
The IRS allows individuals to loan themselves either 50% of their 401(k) balance or $50,000—whichever number is lower. If you default on the plan loan or otherwise fail to pay back the funds, you’ll be taxed on the remaining loan balance as a distribution, and, if you’re under 59 1/2, may also be liable for 10% penalty.
If you do loan yourself 401(k) funds for educational expenses, it’s essential to replenish your retirement account and resume regular contributions in line with IRS rules:
- Typically, you’ll have five years to pay off your loan and make your account balance whole.
- You’ll be required to make regular payments comprised of principal and interest at least every quarter.
- 401(k) loan repayments can come out as deductions from your paycheck, but you may also be able to cut your 401(k) plan a check if you have other resources to settle your debt.
In addition to replenishing your funds, it’s essential to resume regular contributions to your retirement savings so that you can get your retirement plans back on track and make the most of compound growth.
When you make an early withdrawal or loan yourself funds from your retirement savings for education costs, you’ll likely face the following consequences:
- Additional stress on your retirement readiness process
- Potential for costly expenses, like income taxes or early distribution penalty
- Foregone tax-deferred market gains from having your money out of the stock market
- Less disposable income until the loan is paid off (since a portion of your check will go to loan repayments)
It’s almost always a good idea to speak to a financial advisor who can help you balance the demands of paying for college with your own retirement planning. Sometimes, leaving the money invested in your 401(k) and pursuing other loan or grant options can be even more beneficial in the long run.
Other Retirement Accounts
If you have other retirement savings, such as an IRA account or Roth IRA, you may be able to use the funds to pay for qualified education expenses—without paying the typical 10% early distribution penalty. However, if you have a traditional individual retirement account, funded with pre-tax dollars, you’ll still be subject to federal income tax on the entire amount withdrawn.
Roth IRA withdrawals work a little differently. Because contributions are already taxed, you’re always able to remove them without a penalty. If you’ve held the account for at least five years, you can take regular free withdrawals without penalty.
Still, other financial planning drawbacks apply.
Alternative Options for Funding Education
Consider alternative options before using your 401(k) plan to fund education expenses. You can take many routes to fund your own or a family member’s education.
Here are a few:
- 529 plans: These are specifically designed for education savings and offer tax advantages and flexibility, but to get the maximum impact, you’ll need to start saving early.
- Student loans: Explore private and federal student loans, considering the pros and cons of each option by figuring the amount of debt that would be incurred as well the associated interest rate.
- Scholarships, grants, and other financial aid: There are options to receive funding based on merit, need, and other qualifying factors depending on the school or program and your personal circumstances.
- Work-study programs: These can be part of a financial aid eligibility package and are opportunities to make money while studying to help your child afford the educational experience.
Often, individuals will fund their education through a combination of the various options above.
To fully understand your options for funding your education in alignment with your financial goals and financial needs, complete the Free Application for Federal Student Aid (FAFSA) to see how much you might qualify for in federal student loans.
In Summary
It is possible to use your 401(k) to withdraw funds or loan yourself money to pay for education expenses, but this decision can come with some negative implications for your long-term retirement planning.
Using your 401(k) to pay for educational expenses is a decision that requires careful consideration, and you need to account for your individual financial situation, tax implications, the effect it will have on retirement savings, and the other investment options available to you.
Before making a choice, weigh the pros and cons of this option and explore alternative funding sources, such as 529 plans, student loans, scholarships, financial aid, and grants.
Seek professional advice to ensure that you make well-informed decisions and strike the right balance between education expenses and long-term retirement planning.
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