Using Retirement Funds to Pay for College

College is expensive; retirement funds can help fund your child's dream of higher education − or your own.

How? You can withdraw funds from your IRA without penalty as long as the money is used to pay for college expenses. You can also borrow from your 401(k), or if you are under hardship, withdraw funds penalty-free.

First let's take a look at withdrawing money from an IRA to pay for college.

IRA Withdrawals

You can withdraw from an IRA after you reach the age of 59 ½ without facing penalties or paying income tax.

Under normal circumstances, withdrawing early from a traditional or Roth IRA results in a 10% penalty on the amount withdrawn − plus you'll pay income tax on that amount. But, if you take distributions in order to pay for higher education expenses, you are exempt from the 10% penalty (you will have to pay income tax on the portion of the withdrawal subject to income tax, though).

In effect an early withdrawal for education expenses lets you avoid the 10% penalty.

Qualifying expenses must be for you, your spouse, your children, or even your grandchildren. Qualified education expenses include tuition, fees, books, supplies and equipment, and room and board as long as the student is enrolled in a degree program at least "half time."

If you withdraw from a traditional IRA, the full amount of the distribution is subject to income tax. If you withdraw from a Roth IRA, the amount that comes from contributions you made is tax-free while the amount that comes from earnings on those contributions is subject to income tax. In other words: Interest, taxable; contributions, tax-free. If you only withdraw contributions, then, the money you withdraw is tax-free − and you avoid the 10% penalty.

When you withdraw from an IRA and avoid the early withdrawal penalty:

• Your traditional IRA becomes a tax-deferred college savings program.
• Your Roth IRA becomes a tax- and penalty-free program as long as you only withdraw funds you contributed to the plan.
• The money you withdraw is not considered in a financial need analysis and will not affect financial aid calculations (for this year).
• You stay in control of the funds.

But on the other hand:

• The amounts withdrawn do count as income for next year's financial aid calculations.
• Money must be withdrawn during the same year qualifying expenses are paid.
• Qualifying expenses cannot be used to justify multiple savings opportunities; for example, if you use tuition to justify a penalty-free IRA distribution, you cannot use those same expenses as the basis for a Lifetime Learning Credit.
• Each distribution takes away from your retirement savings.

If you are planning ahead, in most cases you will come out ahead using a Section 529 to finance college expenses. Penalty-free and tax-free withdrawals from your IRA makes sense if you find yourself in a bind and cannot pay for college expenses in some other way; otherwise, it makes sense to see withdrawing from a retirement plan as your last resort.

Retirement Plan Borrowing

Instead of making IRA withdrawals you might decide to borrow from your 401(k) plan. If you do, you can pay for college expenses for yourself, your spouse, or your children. Most plans allow you to borrow up to half of the balance of your account; then over time you pay yourself back (you are only allowed to borrow half because the remaining half serves as collateral for the loan).

When you borrow from a 401(k):

• The interest you pay is placed back in your account; in effect you borrow money from yourself and pay yourself back.
• The loan is not considered in a financial aid analysis and will not impact qualifying for that aid.
• The money you borrow remains tax-deferred and there are no penalties or early withdrawal fees.

But on the other hand:

• The loan must be paid back in five years or less.
• If your employment ends − whether you resign, are fired, or are laid off − the balance of the loan may be due immediately.
• If your employment ends and you can't repay the loan, the remaining balance is considered a taxable distribution and you will face a 10% early withdrawal penalty (unless you are over the age of 55).
• The interest you pay yourself is not tax deductible. Plus, the money you use to repay the loan comes from post-tax dollars, so those contributions are no longer sheltered from income tax (regular contributions to a 401(k) plan are sheltered).

If you decide to borrow money, check out federal loan programs like the Stafford loan or the PLUS loan. The interest you pay will probably be less than the earnings your retirement savings would have gained over the same time period. In addition, federal education loans typically offer flexible repayment options, tax deduction possibilities (on interest), and forbearance if you or your child face hardship or if your child decides to continue on with their education.

Just like with making IRA deductions, borrowing from your retirement fund should be seen as a last resort, not as a basic financial planning tool.

Hardship Withdrawals

Keep in mind you can make a hardship withdrawal. The withdrawal must, however, be used to pay for education expenses and you will be required to prove you have no other way to pay for those expenses. If you qualify you will be required to pay income tax and the 10% penalty − a hardship withdrawal is truly a last resort.