Parents Using Retirement Savings for College Costs

Tapping a 401(k) or IRA to pay for college can be expensive.

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Parents typically use their current income and college savings accounts to pay for their children's college costs. But families who haven’t saved enough are increasingly cracking open their nest eggs to help pay tuition bills.

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Some 6 percent of parents withdrew money from a 401(k) or IRA to help cover college costs in 2010, up from 3 percent in 2009, according to a Sallie Mae and Gallup survey of 801 college students age 18 to 24 and 823 parents of college students. The average amount withdrawn from retirement accounts jumped from $5,318 in 2009 to $8,554 this year.

IRAs, but not 401(k) plans, can be used to pay for higher education expenses including tuition, fees, and books without having to pay the usual 10 percent early withdrawal penalty. Room and board also qualify for the exemption if your child is at least a half-time college student. However, IRA owners still have to pay income tax on withdrawals. Roth IRA owners younger than age 59 ½ must pay tax on the portion of the withdrawal that comes from investment earnings.

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College costs can qualify for a 401(k) hardship withdrawal if employees can demonstrate an immediate and heavy financial need for the money and show that other sources of income have been exhausted, according to IRS rules. But workers younger than age 59 ½ will be required to pay a 10 percent early withdrawal penalty in addition to regular income tax on the amount withdrawn. You may also be prohibited from making new contributions to the retirement plan for 6 months or more after the withdrawal.

Families currently receiving federal financial aid need to be especially cautious about 401(k) and IRA distributions. Retirement account withdrawals count as income for the year and could reduce the amount of financial aid your child qualifies for in future years.

Retirement account loans are another option parents are increasingly pursuing. Some 3 percent of parents used retirement account loans to help pay for college this year, up from 1 percent in 2009, Gallup found. Families borrowed an average of $6,901 from their 401(k), up from $5,471 last year. 401(k) account holders can generally borrow 50 percent of the vested account balance up to $50,000. Your employer may require you to pay some fees on the loan. And if you lose or leave your job, the loan balance becomes due. Any portion of the balance that is not repaid is considered a withdrawal and taxes and fees may apply.

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Families that earn over $100,000 a year generally withdrew and borrowed the most from their retirement accounts to pay for college. Parents also used more of their retirement savings to pay for private colleges than public schools. Retirement savers with a child attending a private 4-year college withdrew an average of $1,254 from their 401(k) or IRA in 2010. In contrast, families with a student at a public school withdrew an average of just $414 for a 4-year college and $241 for a 2-year institution.