by Shannon Vasconcelos, former financial aid officer at Tufts University
Parents are increasingly sacrificing their own retirements in favor of their children’s educations. As discussed in the Boston Globe, three-quarters of parents report a willingness to delay retirement in order to pay for college, and, in fact, by 2024 nearly a quarter of those over age 65 are anticipated to be either working or looking for work, almost twice as many as in 1984, the increase aided in no small part by ballooning college tuition rates.
This time of year, when college bills are coming due, I am often asked by parents, “Can I withdraw from a 401k for education?” The sentiment and practicalities behind the question are understandable—parents want to help their kids however they can and a significant portion of parental wealth is held in the family home and in 401ks. While the short answer to this common question is, “Yes, you probably can use your 401k for college,” I think the better question is, “Should I withdraw from a 401k to pay for college?” Here are a few things to think about before making that 401k withdrawal:
- Employers can limit access to 401ks while you are still employed by the company sponsoring the plan. While tuition payments generally qualify for an in-service hardship withdrawal, you may be required to document that you’ve exhausted all other college funding options.
- Traditional 401k withdrawals are subject to taxation at your ordinary income tax rate. When your children are in college, you are likely in your peak earning years and in a higher tax bracket than you will be in during retirement.
- If you are not yet 59 ½ years old, 401k withdrawals are also subject to a 10% early withdrawal penalty. While IRAs offer an exception to the early withdrawal penalty for college expenses, early 401k withdrawals are always subject to a 10% penalty (see new CARES Act exception below).
- Traditional 401k withdrawals are reported as income in the year that you make the withdrawal, increasing your Adjusted Gross Income (AGI). This income increase may not only bump you into a higher tax bracket, but could also reduce financial aid eligibility in a future academic year. To minimize the impact on financial aid, limit 401k withdrawals to your child’s last 2 ½ years of college.
Some 401k programs allow parents to borrow from their 401ks, as opposed to taking withdrawals. While a 401k loan initially sounds like a great college payment option—“I can pay myself back instead of paying back a bank!”—there are a few issues to consider before borrowing from your 401k:
- Most 401k loan programs only allow you to have one loan outstanding at a time. Therefore, you must borrow whatever you need to cover all four years of college all at once (up to a usual maximum of $50,000 or half the account value, whichever is lower).
- Furthermore, most 401k loans must be paid back within five years (see below for coronavirus-related exception). If you’re borrowing enough to cover four years of costs and paying it off in five years, you’re actually not saving much in terms of monthly cash flow over simply paying the four years of costs as they arise over four years. If you can afford to pay back your 401k loan in a five-year time frame, you can probably afford to pay for college out-of-pocket and don’t need to borrow at all.
- If you separate from your employer while your 401k loan is outstanding, the full balance of the loan becomes due by the following tax deadline. If not paid in full by this date, the loan is converted to a distribution, with all tax and penalty repercussions listed in the withdrawal section above.
- In addition, the benefit to utilizing a traditional 401k is that you get to set aside money on a pre-tax basis. If you borrow a 401k loan, you pay yourself back interest with after-tax money. A 401k provides no separation of after-tax interest payments from pre-tax contributions, so when you begin withdrawing from your account in your golden years, you have to pay taxes on the after-tax portion of your withdrawals again! This is one of the very rare occasions in the U.S. tax code where you actually pay taxes on the same money twice. However necessary they may be to the operation of our civil society, most of us don’t particularly enjoy paying taxes. We certainly don’t want to pay them twice!
You may have heard that the CARES Act signed into law in March 2020 provides new flexibilities in accessing 401ks for those that have experienced adverse financial consequences as a result of the coronavirus national emergency. These provisions allow for:
- The waiver of the 10% early withdrawal penalty and 20% tax withholding for coronavirus-related distributions (CRDs) up to $100,000 made in 2020;
- Spreading of the tax liability of CRDs over 3 years;
- Repayment of CRDs without penalty over 3 years;
- A doubling of 401k loan limits to $100,000 or the full account value (whichever is lower); and
- Suspension of 401k loan payments for up to one year (though interest still accrues).
While the CARES Act provisions minimize some of the negative repercussions of accessing your employer-sponsored retirement account early, they do not eliminate all of the drawbacks.
The most important question you need to ask yourself before tapping a 401k to pay for college is, “Will I need this money for my retirement?” For most Americans, the answer to this question is a resounding “Yes!” Very few of us have overfunded our retirement accounts. With life expectancies on the rise, you may be looking at supporting yourself for 30 years or more in retirement, and, with the current uncertainty in our Social Security system, it’s looking like 401k’s are going to necessarily be a primary provider of retirement income. Whether you withdraw or borrow from your retirement account to pay for college, years of potential growth are being sacrificed, possibly putting your retirement at risk.
Alternatively, there are a number of ways to successfully manage college costs without tapping a 401k. If finances are a concern, as they are for most of us (particularly now), be sure your child applies to some colleges where they will qualify for significant need-based financial aid or are likely to be recruited with sizable scholarship offers. Our college finance experts can help you understand your options to pay for college and find scholarships and merit-based aid. Public colleges, including public honors colleges, can be an economical alternative to pricier private schools, and beginning one’s education at a local community college can be an effective means to reduce college costs substantially. Most colleges now offer a monthly payment plan so that parents can budget the tuition bill over the course of the year, and, finally, there are a number of student and parent loans available to help pay for college. In contrast, there are no favorable loans available to finance your retirement. Unless you want to be dependent upon your children in your golden years, you may want to think twice before tapping your 401k to pay for their college. Consider if, in the long run, you are really doing your children any favors.