Parents often tell College Coach’s Saving for College experts that all, or a large part, of their plan to pay for college involves loans or withdrawals from their 401ks or 403bs. We try to help them find an alternative college finance strategy, as using these accounts to pay for college can be expensive and ruin a parent’s retirement security.
A brief reminder: what is a traditional 401k/403b?
When you fund a traditional 401k or 403b, you allow your employer to take some of your paycheck and deposit it in your retirement account. You don’t have to pay taxes on the income that you save. This is called pre-tax salary deferral. You invest the deposit in assets that you hope will grow in value, and you do not have to pay tax on interest, dividends, or capital gains that are earned within the account. This is called tax-deferred growth. When you do withdraw funds from your traditional 401k or 403b, you must pay income tax on those funds. In addition, if you are not yet 59 and a half you have to pay a 10 percent early withdrawal penalty on the withdrawal as well. (Note that account owners may be able withdraw funds penalty-free from a 401k or 403b before they are 59 and a half in rare circumstances, but these exceptions are seldom helpful when the goal is to pay for a child’s college education.)
Many parents tell College Coach experts that they believe that their withdrawals from their 401ks and 403bs will be tax and penalty free if they use the funds to pay for college. Unfortunately, this is a myth. Withdrawals from traditional 401ks are always taxable, and there is no “higher education exemption.”
What’s the impact on the parent’s retirement?
Money withdrawn from a 401k/403b to pay for college will not be available for the account owner’s retirement. Accumulating enough assets to support yourself financially over a long retirement is difficult enough without making early withdrawals, especially those subject to an early withdrawal penalty. Parents who have years to go before they retire will not only have to pay the taxes and penalties associated with an early withdrawal, but they will also lose years of compounded, tax-deferred growth of their investments. As an example, a $50,000 early withdrawal might cost the account owner $13,000 in taxes and penalties today. But not having that $50,000 growing in a tax-deferred account for 20 years would reduce the size of the owner’s retirement assets 20 years later by about $165,000, assuming a six percent annual rate of return on their investments.
How does it impact Financial Aid?
Not only will a 401k withdrawal cost the parent taxes, penalties, and future use of their assets, but it could cost their son or daughter need-based financial aid. As participants in College Coach’s Paying for College program know, need-based financial aid is highly dependent on a figure called “Parent Income.” Unfortunately, withdrawals from 401ks/403bs are added to more traditionally defined income like wages and interest and count when calculating the Parent Income. Colleges are allowed to use their discretion and remove the withdrawal from the income they use in their calculations, but there is no certainty that they will. Even if they do remove the withdrawal income from their calculations in one year, they may not be willing to do so in subsequent years.
What are some alternatives to 401k/403b withdrawals?
Among the alternative strategies for families to consider are:
- Traditional college savings vehicles like 529 Savings Plans, which give families tax-free use of their savings for their children’s college and graduate education, but have similar tax and penalty issues as 401ks/403bs when not used for college expenses.
- Taxable parent owned assets that can be used for anything the parents want, including a child’s college and the parent’s retirement, and may be subject to the lower capital gains rate than a 401k withdrawal.
- Parent-owned Individual Retirement Arrangements, which are exempt from the 10 percent early withdrawal penalty when used to pay for a child or grandchild’s higher education.
Keep an eye out for a future blog in which we’ll discuss borrowing against your 401k.