Tapping a retirement plan to pay for college

E*TRADE Securities2 

03/16/17

There’s an old saying: a child can attend college by taking out a loan, but there is no such thing as a retirement loan. While this is true, this article will explore some ways to withdraw funds from a retirement account in order to help a child with rising college costs.

As background, according to the College Board's Trends in College Pricing, the 2015-2016 average annual costs of higher education (including tuition and fees, room and board, books and supplies, transportation, and other expenses) were $19,548 for in-state students attending four-year public colleges and universities, and $43,921 for students at four-year private colleges and universities. In addition, college costs tend to rise higher than the average inflation rate. Over the decade from 2005-2006 to 2015-2016, four-year public college costs increased at an average rate of 3.4% per year beyond the rate of general inflation. With the rise in college costs, many may be wondering how to help a child pay for this important experience.

If funds have been set aside in education savings plans, such as a 529 plan or Coverdell ESA, these accounts should be tapped first in order to pay college costs. After dollars in these plans are depleted, many advisors recommend using a home-equity loan or line of credit, since these may offer a low interest rate and a tax deduction on the interest payments. Additionally, parents may be able to borrow from the government-sponsored Plus Loan program at a low interest, provided income doesn't exceed the phase-out levels. However, there's one drawback: interest and principal payments start right away on the loan.

For parents looking for a way to pay for college without having to pay it back, they can dip into their retirement savings—provided they understand that it may lead to a shortfall during their retirement years. To tap into a Traditional or Rollover IRA and if the parent is under age 59½, one option is to take a premature distribution to pay for qualified education expenses. Distributions are subject to income tax, but are exempt from the 10% penalty. The qualified higher education expense must be for the parent themself, a spouse, children, or grandchildren. Qualified higher education expenses include tuition, fees, books, supplies, and equipment, as well as room and board, if the student is enrolled at least half time in a degree program.

To withdraw from a Roth IRA and if the parent is under age 59½, if  withdrawals are limited to only the contributions previously deposited, or Roth conversions that were completed more than five years ago, the withdrawals are tax-free. If the parent is over age 59½ and has held the Roth IRA for at least five years, any amounts withdrawn (contributions, previous conversions, and earnings) are tax-free.

To withdraw from a 401(k) or other qualified plan, a parent generally has two options—take a loan or withdraw a hardship distribution. With a loan, participants are generally allowed to borrow up to 50% of their vested account balance to a maximum of $50,000. Funds obtained from a loan are not subject to income tax or the 10% early withdrawal penalty. However, loans must be paid back over five years. Additionally, if the parent leaves the job for any reason, they generally would have only 30 days to pay off the remaining balance of the loan or face paying income taxes and a 10% penalty on the unpaid balance. With a hardship distribution, the plan must contain specific language that allows hardship distributions to be used for education expenses. A qualified plan may, but is not required to, provide for hardship distributions. Make sure to check with the plan administrator to determine if a hardship distribution can be used to pay for education expenses, such as the next 12 months of post-secondary education for the participant, the participant’s spouse, children or dependents. In addition, hardship distributions are subject to a 10% penalty, if the parent is under age 59 ½, and ordinary income taxes are paid on the withdrawal amount at any age.

If a parent has many years to go until a child reaches college, it is beneficial to start saving early. This way, dollars are more likely to grow into a meaningful sum to help the child. There are ways to explore tax-free savings and investing, such as a 529 plan or a Coverdell ESA, which could lessen the need for financial aid or to tap into a retirement account to cover costs. In addition, many parents expect children to contribute their own money to college by taking out student loans or working part-time before and during their college years. Above all, saving for education should start as soon as possible to achieve maximum growth.  The greater the growth, the greater the number of choices one has when deciding which college to attend.

So bottom line: can retirement accounts be used to save for college? Yes. Should they be? Not if doing so will leave a parent with insufficient funds in their retirement years. However, a parent can certainly tap retirement accounts to help pay the college bills if they want to.

For further information about an IRA, or answers to any retirement planning or college savings questions, call 1-877-921-2434 or visit an E*TRADE branch.