More Parents Use Retirement Accounts to Pay for College

Be prepared for taxes and penalties if you use a 401(k) or IRA for college costs.

By Emily Brandon
Sept. 2, 2014 | 10:09 a.m. EDT - US News & World Report

Some families dip into their retirement accounts to help pay for college. A Sallie Mae and Ipsos survey of 1,601 college students and parents of undergraduate students found that 7 percent of families took a withdrawal from a retirement account to help cover college costs in 2014, up from 5 percent in 2013. The average retirement account distribution also grew from $2,710 in 2013 to $8,870 in 2014. And 1 percent of families took retirement account loans to pay for college, with loans averaging $5,062 in 2014, up from $3,952 in 2013.

However, using a retirement account to pay for college can trigger a variety of penalties and fees. "You take money out of your retirement account and you pay penalties, you pay taxes, you lose the value of the retirement account and it is much harder to put that money away,” says Sarah Ducich, senior vice president of public policy at Sallie Mae. "It gets counted as income for the student’s financial aid calculation and sets you back in how much aid you can qualify for next year.” Here are the taxes and fees to watch out for:

Avoid the early withdrawal penalty. Hardship withdrawals from 401(k)s can be used to pay for tuition and related educational expenses. However, hardship distributions from traditional retirement accounts taken by people under age 59½ are subject to a 10 percent early withdrawal penalty in addition to income tax on the amount withdrawn. Additionally, many employers prohibit workers from making new contributions to the 401(k) plan for at least six months after a hardship distribution, which means workers lose out on the tax breaks for new 401(k) contributions. This makes it especially difficult to begin rebuilding a nest egg for retirement.

However, the early withdrawal penalty is not applied to individual retirement account distributions that are used to pay for higher education expenses including tuition, fees, books, supplies and required equipment for you, a spouse, your children or grandchildren. Room and board are also qualifying expenses for at least half-time students.

Be prepared to pay income tax. Income tax will be due on traditional 401(k) and IRA withdrawals that are used to pay for college. A worker in the 25 percent tax bracket who withdrawals $10,000 from an IRA for college expenses will owe $2,500 in federal income tax on the distribution. However, if the money is withdrawn from a Roth IRA before age 59½, income tax will be due only on the portion of the withdrawal that comes from investment earnings. “Generally speaking, a Roth IRA would be a better way to take it out because you won’t have to pay the taxes, and you will be able to use that full account value,” says Nick Rugh, a financial planner for Rugh Financial in Palo Alto, California.

Consider a retirement account loan. Participants in 401(k)s are typically eligible to borrow as much as 50 percent of their vested account balance up to $50,000 if their plan permits loans. However, 401(k) loans for college costs must be paid back with interest within five years. If successfully paid back, a 401(k) loan can result in less damage to your retirement nest egg than a withdrawal because no taxes are typically due on the loan and you can put the money back in the account relatively quickly. “A loan would mean that you are required to pay it back, and essentially you have to put the money back in your 401(k), so you aren’t taking it out and it’s gone,” Rugh says. However, if the loan is not paid back or you lose or leave your job, the outstanding loan balance becomes a distribution and taxes and penalties will be applied to it.

Your financial aid could be reduced. Withdrawals from 401(k)s, IRAs and Roth IRAs are considered income and could reduce the amount of financial aid a student qualifies for. Waiting until your child’s senior year of college to take a retirement account withdrawal could help ensure that his or her financial aid package won’t be reduced. “If you are eligible for need-based financial aid, you do not want to take distributions from a retirement account,” says Kalman Chany, founder and president of Campus Consultants and author of “Paying for College Without Going Broke.” “The reason for that is the distribution, whether it is taxable or untaxed, is going to be considered income in the aid formulas and reduce your aid.”