You work hard to put away money each month in your 401(k). Seeing the growth over the years helps you feel secure about your retirement.
Until the first bill for your child’s college tuition arrives.
Finding the funds to cover the cost of college can be difficult — you may be tempted to use your 401(k) as a way to help pay for your child’s college education. But is it the best idea? Let's dig in to what you can and can't do with your retirement funds — and what you should consider before you make your next move.
Can you withdraw from a 401(k) for education expenses?
Yes, you can generally take an early withdrawal from your 401(k), but it's important to know that doing so can come with serious and costly consequences.
First, there are hoops you may have to jump through just to access the funds. Some employers may limit access to your 401(k) while you are still employed. That means you have to prove a hardship to be considered for a loan. Even then, your employer may require you to provide proof that you've exhausted your other options to fund college.
Plus, if you're under 59 1/2 years of age, and still working for the employer that sponsors the plan, you will incur taxes. IRS will charge a 10% early withdrawal penalty on the amount you take out. That's in addition to the usual income tax you would pay on the distribution.
What's that mean in terms of actual dollars? Well, it'll depend a bit on your personal financial situation, but it's significant. For example, let's say you want to withdraw $10k to cover your student's tuition gap, you're in the 22% tax bracket, and you also pay 1% in state taxes. Between the penalty and taxes, that $10k withdrawal would be whittled down to only $6.400 in your pocket. (To get the full $10k in hand, you'd have to withdraw approximately $16k.)
That also doesn't account for the lost growth if you'd left that $10k in the account. Exactly how much you'd lose depends on how aggressively you invest and how long you have until you retire, but if you're 20 years from retirement and average an 8% return on your 401(k), the hit to your future retirement savings from withdrawing that $10k would be more than $46k. Between taxes and lost growth, paying $10k in college costs from a 401k withdrawal could cost you more than $50k. People often think taking the money from a 401(k) is cheaper than taking out a loan, but as you see, that may well not be the case.
You can use this calculator to plug in your details and get a more personalized look at the costs of borrowing from your 401(k) for college.
Can you borrow from a 401(k) for education expenses?
Instead of an early withdrawal, you may be considering taking a loan from your 401(k) to pay for college.
In many cases, it's possible to take a loan from your own retirement account. If you decide to do so, you then become the lender — but you're also responsible for making payments back to your retirement account.
Typically, you have five years to pay back the loan. Any longer than that, and you may have to pay income tax or fees on the amount you borrowed. And if you leave your job (voluntarily or otherwise), you may be required to pay it back by the next tax filing deadline. If you default on the loan, it's considered an early withdrawal, and the penalties and taxes we talked about above will apply.
You should also know your 401(k) isn't a bottomless pot of potential money to borrow. There is a limit to how much you're allowed to borrow from your 401(k) — $50k or 50% of your vested value, whichever is smaller. (Note: The vested portion consists of the funds in the account that you fully own. You are always 100% vested in your contributions; usually you become vested in your employer's contributions a certain percentage each year over 3-7 years.) Normally you can find your vested balance fairly easily on your account page or account statement.
Should you use a 401(k) for education expenses?
If you’re still contemplating borrowing or withdrawing from your 401(k), ask yourself this question: “Do I need the money that's in my 401(k) for retirement?"
If the answer is “yes,” you should not be using these funds for college expenses.
At some point, you'll want to retire. (And a lot of people end up having to retire earlier than they planned for health reasons.) If you’ve been taking money out of your 401(k) to help fund your child’s education, you may jeopardize your own retirement. You or your child can borrow money for college. You cannot borrow money for your retirement.
You should also consider that your child has their entire life to pay back student loans. But you have fewer years left in the working world. You need to protect your financial future. That may sound harsh, as if you're putting your needs ahead of your child's. But consider this: Leaving yourself in a financially precarious position for your retirement will create other, equally unpleasant difficulties for your child. (Do you want them worrying about how to pay for the medical care you need? Or having to buy a bigger house than they can truly afford just so they can have you stay with them? Didn't think so.)
Prioritizing your retirement isn't selfish. It's the financial equivalent of what pilots say in their preflight warnings: Put your oxygen mask on first so you're able to help those around you.
What can you do instead of using a 401(k)?
Since taking out a withdrawal or a loan on your 401(k) is generally not a good idea, you might be wondering what other options you have if you have a tuition gap after you've exhausted scholarships, grants, and federal loans.
One way to help cover the difference is to consider taking out a private student loan.
You have two options when it comes to private student loans:
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You can take out a loan in your name, or
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You can cosign a loan with your child (their name is primary).
If you choose to take out a private student loan rather than using your 401(k) funds, you can borrow the money you need without compromising your retirement.
Often, the terms are quite reasonable, which allows you to find room in your budget to make a payment on a private student loan.
If you decide to pass some of this responsibility onto your child, you can cosign a loan with them. Your credit is used to determine eligibility for the loan, which can result in a lower interest rate.
Plus, some lenders will release you as the cosigner once your child has made a total of 24 consecutive, on-time payments.
However, when you cosign a loan, you agree to take on all financial responsibility if your child defaults on their payments. That's something to consider, especially since it can negatively impact your credit score.
If you want to learn more about how a private student loan can help fund your child’s education, check out our guide to The Best Private Student Loans.