Can You Withdraw from a 401K for Education?
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. 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.
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—no exceptions.
- 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.
- 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 maximum of $50,000 or half the account value, whichever is lower).
- Furthermore, most 401k loans must be paid back within five years. 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!