According to the National Center for Education Statistics, the average annual cost to attend a 4-year public university in the U.S. was a whopping $21,337 for the 2020-2021 school year. And that cost climbs to $29,033 per year for a 4-year private university. Given the high price tag of a college education, it’s easy to understand why a parent might consider dipping into their 401(k) to help cover the cost. But is taking an early distribution allowed? And is it a smart move? Here’s what to know about using a 401(k) withdrawal for education and alternatives if federal student loans aren’t enough to cover the cost.
Can You Use a 401(k) for College?
Most retirement accounts have special rules about when you can start making withdrawals, and 401(k)s are no exception. While different plans have different rules, you generally need to be at least 59 ½ before you start taking distributions from your 401(k), or you’ll pay a 10% penalty in addition to regular income taxes. But you might be able to take an early distribution from your 401(k) if federal student loans won’t cover the full cost of your child’s college education, and paying for it represents a significant financial hardship. Remember that some plans might not allow you to do so, though. Check with your plan administrator if you’re considering this option.
Alternatives to Using a 401(k) to Pay for College
While you may be able to use a 401(k) to pay for college, it’s probably not the best idea. You’ll need to pay taxes on the amount you withdraw, and you’ll also probably pay a 10% penalty. Plus, you’ll lose out on some of your hard-earned retirement savings, and you won’t reap the full benefits of compound interest. But given the high cost of college, dipping into your retirement nest egg might be necessary to pay for your child’s education. If you need to do this, consider an IRA distribution instead. The rules about distributions are slightly different with an IRA, and you can make tax-free and penalty-free early withdrawals for qualified expenses, including higher education costs. While funding your child’s college tuition might be a worthy cause, you’ll still be losing out on some retirement savings. Another alternative to taking a distribution from your retirement account is private student loans. You’ll pay interest with a private student loan (as you would with nearly all loans,) but your borrowing costs will be lower than the cost of a retirement account withdrawal after accounting for the taxes, penalties, and lost interest.
Retirement Account Distributions vs. Private Student Loans Compared
If you’re trying to determine the best and least expensive way to pay for college, it can help to compare the cost of a retirement account distribution vs. a private student loan. Let’s say you need $20,000 to cover a tuition shortfall. If you take a $20,000 401(k) distribution and you’re in the 22% tax bracket, you’ll pay $4,400 in federal taxes on the amount withdrawn as well as a $2,000 penalty. You’ll also need to pay state taxes, which vary. So the cost of this distribution would be over $6,400. And that $6,400 doesn’t account for the loss of retirement value, which is more significant. For instance, if you have 20 years until you retire, that $20,000 distribution could cost you over $70,000 in retirement savings between the distribution amount and potential gains. While you won’t pay taxes or penalties on an IRA withdrawal for a qualified education expense, you’ll still lose out on that retirement value if you take a $20,000 distribution. Alternatively, let’s say you take out a 10-year $20,000 private student loan with a 3.5% interest rate and no origination fees, application fees, or prepayment penalties. Over the life of the loan, you’d pay around $3,700 in total interest, making it a much more affordable option than dipping into your retirement savings.
The Bottom Line
College is very expensive, and you may be thinking about withdrawing money from your retirement account if federal student loans aren’t enough to cover the cost. But this isn’t always the best solution, given the taxes, penalties, and loss of potential value of your retirement savings. A private student loan with a low-interest rate can be a much more affordable alternative.
