Can a 401(k) Pay for Grad School?

A college savings account lets you avoid taxes and withdrawal penalties.

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Dear Alpha Consumer,

I am currently working and plan to attend business school in fall 2009. I want to save as much as I can in advance and also avoid as much tax as possible. If I contribute toward my 401(k) plan, will it be possible to withdraw the money without any penalty and taxes?

The short answer is no. In general, workers with 401(k) accounts can't make early withdrawals without paying a 10 percent penalty. There are exceptions, including for "hardship" situations, but going to business school is not likely to qualify. And it is possible to take a loan out against a 401(k), but there are plenty of reasons to avoid that, including the fact that you'll miss out on years of compounding. However, if you are confident that you will repay it and catch up on retirement savings later, a loan is one option to consider. (Be sure to check that your company's plan allows taking out the loan even while you're not employed there; some plans don't.)

An even better option, suggests Perry Chlan of the Fidelity Research Institute, is to save up in a 529 plan, which is a tax-sheltered account designed for college savings. Such accounts generally can be used for graduate school, too. That way, you can avoid paying taxes and a withdrawal penalty.