Dipping Into Your Retirement Account to Pay for College

The type and timing of your withdrawal will determine the taxes and fees you pay.

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Parents typically pay for college using their current income, 529 college savings plans, and other savings or investments. But some parents who haven't saved enough dip into their retirement accounts to pay for college.

Some 4 percent of parents withdrew money from their 401(k) or IRA to pay for college in 2011, according to a Sallie Mae and Ipsos survey of 813 college students and 798 parents of college students. The average amount withdrawn was $4,102. Another 1 percent of families took a retirement account loan, borrowing an average of $2,779 to help cover higher education costs.

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When using retirement accounts to pay for college, the type of retirement account and the timing of the transaction can determine how much of your savings will be applied to the tuition bill. And, of course, withdrawals and loans can hurt your retirement security. If you're considering tapping your nest egg for college costs, here's what you need to watch out for.

Avoid the early withdrawal penalty. Tuition and other education 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 financial resources have been exhausted, according to IRS rules. But 401(k) account owners will still have to pay income tax, and if they're younger than 59½, they'll be hit with a 10 percent early withdrawal penalty. "The real problem with using the traditional 401(k) to pay for college is that they get really penalized," says Sarah Ducich, senior vice president of public policy at Sallie Mae. "They get a penalty for early withdrawal, they get taxed at a higher rate for the withdrawal, and then for the financial aid calculation for the following year it is counted as income." Workers may also be prohibited from making new contributions to the 401(k) plan for six months or more after the withdrawal.

However, you can avoid the 10 percent early withdrawal penalty before age 59½ if you use an IRA distribution to pay for college. IRA, but not 401(k), withdrawals applied to higher education expenses including tuition, fees, and books are exempt from the penalty. Room and board are also qualifying expenses if the individual attending college is at least a half-time student.

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Pay attention to the tax treatment. You will need to pay income tax on both IRA and 401(k) withdrawals, which could result in an abnormally large tax bill. However, Roth IRA owners younger than 59½ pay income tax only on the portion of the withdrawal that comes from investment earnings. "The money you put in a Roth IRA comes back to you tax- and penalty-free when it is used for higher education purposes," says Tim Higgins, a certified financial planner in Marlborough, Mass., and author of Pay for College Without Sacrificing Your Retirement: A Guide to Your Financial Future. "You only owe taxes on the growth."

Look at loans. Account holders of 401(k)s can generally borrow 50 percent of their vested account balance, up to $50,000. But it's important for parents to explore the terms of all the loan options available, including Federal PLUS Loans, home equity loans, and private education loans, before borrowing from their retirement accounts. "If you are going to borrow, determine the best place to borrow," says Higgins. "If you are doing parent borrowing, I would look at equity in your home first."

Loans from 401(k)s that are used for education expenses must be repaid within five years, and your employer may require you to pay some fees for the loan. If you leave your job, the loan balance becomes due, and any portion of the loan that is not repaid is considered a withdrawal and taxes and fees may apply.

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Consider your financial aid package. Families receiving federal financial aid need to be especially cautious about retirement account distributions. Withdrawals from 401(k)s and IRAs count as income for the year and could reduce the amount of financial aid the student qualifies for in future years. "If you're doing this during the senior year of college, it will not have an impact, but if you do it in earlier years, it can have a severe negative impact on your financial aid," says Mark Kantrowitz, publisher of FinAid.org and author of Secrets to Winning a Scholarship. "Between the taxes and the reduction in need-based financial aid, you are potentially only going to net pennies on the dollar." Try to delay retirement account withdrawals until your child's senior year of college, to ensure that their financial aid package won't be reduced.