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3 Reasons Why You Shouldn't Use Your 401(k) to Pay for College

By Maurie Backman - Apr 2, 2016 at 7:03PM

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It's just a bad idea -- no matter how you look at it.

With college costs climbing at an obnoxiously relentless pace, the pursuit of higher education has become, for many, a financially stressful prospect. And some parents are getting desperate enough to dip into their retirement savings to help their children cover tuition costs. In a 2014 study, 7% of families admitted to taking funds out of a retirement account to pay for college, up from 5% the year before. Worse yet, the average withdrawal jumped from $2,710 in 2013 to $8,870 in 2014. And among families who borrowed from their retirement accounts, the average loan amount was just over $5,000.

Image source: Pixabay.

It's easy to understand the appeal of using a 401(k) to finance college. After all, that money is yours already, and it's just sitting there in an account doing nothing, so you might as well use it, right?

Wrong. Taking money out of a 401(k) to help pay for college is actually one of the worst moves you could make. Here's why.

1. You'll get hit with penalties and taxes.
Normally you need to wait till you're 59-1/2 to remove money from your 401(k), but most plans contain provisions for hardship withdrawals. Under certain circumstances, you're allowed to take money out early, such as to prevent foreclosure on your home, purchase a primary residence, or pay for higher education expenses. But just because you're technically allowed to use that money doesn't mean you won't get penalized. If you remove money from your 401(k) to cover college costs, you'll be assessed a 10% early withdrawal penalty, because no exception to the penalty applies for 401(k) withdrawals used for educational expenses. Not only that, but you'll receive a 1099 listing the withdrawal amount, which will count as income on your taxes.

Say you take out $10,000 and your effective tax rate is 30%. What this means is that you'll essentially lose $3,000 of that withdrawal to taxes. Now if you borrow money from your 401(k) and repay it rather than withdraw it outright, you'll avoid the up-front penalties and taxes, but you'll still get zinged from a tax perspective. When you repay a 401(k) loan, you're doing it with after-tax dollars. Then, when you withdraw that money in retirement, you'll be subject to taxes again, because that's how 401(k) plans work. Talk about a double whammy.

2. You'll fall behind on retirement savings.
Some people who take money out of their 401(k)s to pay for college do so with the intention of paying it back. But even if you have every intention of replenishing the funds you withdraw, you may find yourself unable to do so in time to avoid penalties. If you borrow for college from your 401(k) but don't repay your loan, you'll be subject to the same taxes and penalties of an early withdrawal. Furthermore, most plans stipulate that once you borrow from a 401(k), you can't make additional contributions until you've repaid the amount withdrawn. And if you wind up taking an early withdrawal, be it intentionally or as a result of not being able to repay a loan, you'll most likely be unable to contribute to your plan for six months.

Whether you're blocked from adding money to your 401(k) because you borrowed against it or withdrew funds early, the end result is the same: You'll miss out on potential employer matching dollars and tax-deferred earnings for as long as you're prohibited from contributing, which could set you far behind in reaching your ultimate retirement savings goal.

3. You can borrow money for college, but you can't borrow for retirement.
Though the student debt crisis is far from a good thing, the fact that it exists highlights one important point: There are loans out there to help pay for college. There aren't, however, similar loans to help pay for your living expenses in retirement. If you sacrifice your 401(k) balance in the hopes of lowering your child's student debt burden, you risk running out of money once your working days are behind you. And if that happens, you'll have no choice but to resort to high-interest credit cards, if that's even an option. Using a 401(k) to pay for college is a risky prospect no matter how you look at it. Remember, college technically isn't a necessity, but you can't say the same thing about housing, healthcare, and food in retirement.

If you've already exhausted your federal loan options for college and are still facing a shortfall, you may want to consider a home equity loan, whose interest is at least tax-deductible (provided that you itemize). Another option to look at is withdrawing money from a Roth IRA rather than a 401(k). Though you'll still run the risk of jeopardizing your retirement nest egg, because Roth contributions are made with after-tax dollars, you won't be taxed on the money you withdraw (though you will get taxed on your earnings). More importantly, you won't be hit with that 10% early withdrawal penalty as you would with a 401(k).

Before you make any plans to use your 401(k) for college purposes, remember this: The reason you opened that account in the first place was to fund your retirement. Keeping that money locked away where it belongs isn't being stubborn, or selfish; it's being smart and playing it safe.

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