Can and should you take money out of your retirement plan to pay for your child's college education?
In: Retirement Planning

Look, I get it.  Your son or daughter is getting ready to go to college.  You realize you haven’t saved enough and you want to consider every possible solution to help your child be to afford a solid college education.

Perhaps you have been saving in a 529 plan or perhaps just a taxable brokerage account.  Whatever the case it’s not enough.  Well, with the rising costs of higher education it’s not easy to save the total amount needed for a child to go to college for four years.

Even grandparents are trying to figure how to help pay for college expenses for their grandchildren.  Costs for education continue to go up, and many parents do not have enough saved in their specific college funds to pay for all of it.

Where is the best place to get the money to help supplement your college savings plan?

In a lot of cases, the only other place people have money saved is in retirement accounts.  Is withdrawing money from an IRA or a 401(k) or some other type of retirement plan a good idea?

Well the short answer is that it depends.  It depends on what you ask?

For one thing, would you have to pay penalties if you withdraw money from your retirement accounts?

Now…there is an exception to the 10% early distribution penalty for higher education expenses.  But, the exception to the penalty only applies to distributions made from IRA accounts, including SEP and SIMPLE IRAs.

You see some retirement plans can be accessed without a penalty while others cannot.  The exception does not apply to a distribution from an employer plan.  So, you can do this without penalty only if you have personal retirement accounts, like an IRA.

However, there are some things you need to be aware of, along with some strict rules and limitations to qualify for the penalty exception which you must know.

First, a distribution from an IRA of pre-tax funds will of course be taxable, so you have to consider that first.  If you feel you will be in a lower tax bracket in retirement, then taking out this money now will cost you more money.

The next thing to understand is that the distribution must be made in the year the expense is incurred. This is important to know because in the case of a loan or expenses put on a credit card, distributions made in later years to pay off those bills will not qualify for the penalty exception.

Next, there is no dollar limit for the exception. However, it only applies to qualified higher education expenses, such as tuition, room and board, required fees, books and supplies.  Computers and related technology are also a qualified educational expense even if they are not specifically required by the school.

Finally, the exception applies to the IRA owner, their spouse, and any child or grandchild of either the IRA owner or the spouse.

So, for some retirement accounts, you can access this money without penalty.  But, the question you still need to consider is…should you do this?  Well, again, the answer is it depends.  It depends on a lot of factors.

This is something you definitely want to discuss with your financial or retirement advisor.  In general, I believe that it’s not a good idea to take money from your retirement savings to pay for your son or daughter’s college education.

Believe me.  I get it.  And I realize I don’t have children yet, but one day my wife and I will.  I am told “Ryan, you don’t have kids yet so I think it is harder for you to really understand.”  I concede that I might feel a little differently once I have kids of my own.  Nevertheless, let’s focus on the financial part of this and what makes most sense.

I suggest you keep this in mind…

You can borrow to finance college.  You cannot borrow to finance your retirement.

Today, with interest rates near historic lows, it very well may make sense to look for loan options instead of a withdrawal from a retirement plan.  It just depends on each person’s unique and specific situation.

Now, if you’re going to use your retirement funds to finance an education, you have to make sure you do it right.  Again, in a lot of cases, I believe this should only be used as a last resort when all other sources of funding have been exhausted.

Remember, once funds are removed from a retirement plan, it is very difficult to make up those funds since contributions back into the retirement plan are limited.

For example, for an IRA, it is $5,500 a year for those under the age of 50, and $6,500 if you are age 50 or older during the year.   Plus, IRA contributions must stop once you reach the year you turn 70 ½, even if you are still working.

In addition to the loss of the amount of the withdrawal, you also lose the earnings on that amount – each year – and the earnings on the earnings. As I have mentioned several times before, compound interest is a powerful force in a retirement account.  Losing that is a big issue.

So by taking the money out for college education, you are most likely digging a hole that you may never climb out of.  The question you want to ask yourself is, “Will this hurt less than a cost of a loan?”  Perhaps it will and perhaps it won’t.

Again, should you access money from retirement funds to pay for a college education?   It really depends on each person’s financial situation.  How much do you have saved?  Are you on track for retirement?  When do you plan to retire?  How stable is your job?  Do you have any debts?  If so, what debts to you have?  How much is needed to pay for college?  I’ll say it again that each person’s situation is truly unique.

It really is a balance isn’t it?  You want what is best for your kids and you want to make sure your financial future is secure as well.  Make sure you talk to a retirement and financial planning professional to get the help you need to navigate through these issues and help you make smart and informed decisions.

 

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