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Should You Raid Your 401(k) to Pay for College?

The day your employer sat down with you to go over your new 401(k) retirement plan, you might have discussed several things — allocation amounts, employer matching and age-based investing, for example.

 

You also might have gone over the different options for borrowing against your retirement plan, along with the penalties for cashing it in early. Hopefully, at no point did you toy with the idea of using your 401(k) funds to finance your child’s college education.

 

Why Is That a Bad Idea?

The short answer is, whereas your student has multiple options for college funding, there is no such thing as a grant or financial aid for retirement. Like securing your own oxygen mask first on an airplane, you need to protect your retirement savings even as you guide your child toward college funding resources.

 

To put things in perspective, consider the following questions: How would you fund your retirement if you didn’t have a 401(k)? Would you work longer? Reduce your standard of living? Rely on your children? What if they are not in a financial position to help you?

 

Your kids will have plenty of time to repay loans and start making their own way after college. How much time will you have to make up for pulling money out of your retirement?

 

There Are Better Alternatives

Although it might seem like raiding your 401(k) is a quick and easy solution in the short term, the long-term ramifications should give you pause. The following sources are much better alternatives that will get your student the money that’s needed but won’t leave you high and dry in retirement.

 

Institutional, state or federal student loans

Start by applying to federal and state student loan programs, which offer the lowest fixed interest rates and the most flexible repayment plans. In addition, they are not entirely dependent on an applicant’s credit history, and they’re often need-based.

 

Apply for private loans from banking institutions and other sources only after you have exhausted your other options, including those outlined below. The terms and interest rates will not be as forgiving. However, for those with a strong credit history (and perhaps a cosigner if the lender requires one), private loans can help to cover any unmet financial needs.

 

Grants and Scholarships

Who doesn’t love free money? That’s what you get with grants and scholarships for which you qualify, meaning you never have to repay the money. Whereas scholarships are often merit-based and dependent on factors such as grades, grants are often need-based and dependent on income.

 

You can get either or both through federal and state governments, your chosen college, and private or nonprofit organizations. Begin your research early, apply on time, and go after anything big or small that’ll help offset the overall college costs. Every penny counts!

 

Coverdell Education Savings Accounts

For education expenses incurred during a student’s elementary, secondary or college years, a Coverdell Education Savings Account (ESA) allows you to set aside up to $2,000 of post-tax dollars annually.

 

The money grows tax-free, and withdrawals used toward the beneficiary’s qualified education expenses may be tax-free as well. Note: Some portion may be taxable, as in cases where the family is claiming the American Opportunity Tax credit or Lifetime Learning credit.

 

529 Plans

Set up a 529 plan to set aside post-tax money that’s to be used solely for covering qualified higher education expenses. Many parents and grandparents establish these accounts with the child as beneficiary when the child is quite young. The money grows federal tax-free and is not taxed when the money is withdrawn for college.  

 

Uniform Gifts to Minors Act or Uniform Transfer to Minors Act (UGMA/UTMA)

The Uniform Gifts to Minors Act (UGMA), aka Uniform Transfer to Minors Act (UGMA/UTMA), offers a way to gift thousands of dollars’ worth of assets annually to a minor without tax consequences. The donor must appoint a trustee to act as custodian of the monies.

 

Qualifying U.S. Bonds

U.S. savings bonds are a low-risk investment option that are immune to any market changes. With a modest return on investment, bonds are backed by the federal government and can be replaced by the U.S. Treasury Department if lost or stolen.

 

As you can see, with all of the options for funding a college education, it’s not necessary to tap into your 401(k). With research, careful forethought and the help of a financial planner, your student’s education costs can be well-covered.

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