Paying for College with Your 401(k): Wise Move or Bad Choice?

Joen KinnanBy Joen KinnanBy Savingforcollege.com

As an alternative to traditional student loans, borrowing against your 401(k) to pay for a child’s or grandchild’s college education presents advantages and disadvantages. Experts caution against 401(k) loans because they will impact your own retirement situation. However, a 401(k) loan might be a viable option for you under certain circumstances. In other cases, it may be the only option.

There are more drawbacks than benefits to using your 401(k) in any form as a means to finance your child's college education. Before you take a 401(k) loan or hardship distribution, consider all other available options.

Reasons to Borrow from your 401(k)

There are several advantages to borrowing from a 401(k) to pay for college.

  • You can get a 401(k) loan even if you have bad credit because 401(k) loans do not require credit underwriting.
  • When you borrow from a 401(k), you pay the interest to yourself. With other loans, you pay the interest to a third-party lender.
  • The interest rate on a 401(k) loan will probably be lower than on most other loans, except for loans from the federal government. The interest rate on a 401(k) loan is typically the Prime Lending Rate plus one percent, which is lower than the interest rate on a Federal Parent PLUS Loan, but higher than the interest rate on a Federal Stafford Loan.
  • A 401(k) loan does not involve any fees. In contrast, Federal Parent PLUS loans have fees in excess of four percent. While private student loans don’t technically have fees, the fees are bundled into the interest rate.
  • Your home will not be used as security for repayment of a 401(k) loan as it would with a home equity loan or line of credit (HELOC).
  • A loan from your 401(k) does not appear on your credit history even if you default on the loan.
  • You might feel more comfortable borrowing from yourself than from strangers.

Reasons Not to Borrow from your 401(k)

There are several disadvantages to borrowing from a 401(k) plan that can reduce your retirement savings.

  • A 401(k) loan is a short-term loan. A 401(k) loan must be repaid within five years, so it isn’t very suitable as a means for paying for a four-year college program.
  • The amount of money you can borrow is limited. A 401(k) loan may be limited to $50,000 or half the vested balance in your 401(k), whichever is smaller.
  • With some 401(k) plans, you won’t be able to make pre-tax contributions to the 401(k) until you’ve repaid the loan. Until the 401(k) loan is repaid, you’ll lose the benefit of a reduction in taxable income from the pre-tax contributions to your 401(k)
  • If your employer matches your contributions to your 401(k), you’ll lose that benefit too. Since you won’t be contributing to your 401(k), neither will your employer until the 401(k) loan is fully repaid.
  • If you lose your job, you will have only 60 days from the date of your job loss to repay the 401(k) loan in full. That could put you in a difficult financial position.
  • If you are unable to repay the loan against the 401(k), the IRS will regard the money you borrowed as taxable income. This puts you in double jeopardy: you can’t replenish your 401(k) plan loan and you’ll have to pay taxes on the loan.
  • If you’re unable to repay the loan and you are under age 59 ½, you will have to pay a 10 percent penalty on the 401(k) distribution.
  • Though your 401(k) will receive interest income from the 401(k) loan, that interest is merely a replacement for the income you would have received had you left the money invested in the retirement plan.
  • The interest you pay on your 401(k) loan is not tax deductible, unlike the student loan interest deduction for up to 42,500 in interest paid on a Federal Parent PLUS loan or a private student loan.
  • The money in a 401(k) comes from pre-tax contributions, whereas a 401(k) loan is repaid in after-tax dollars.

Hardship Distributions from a 401(k) to Pay for College

As an alternative to a 401(k) loan, you might take a hardship distribution from your 401(k) plan to pay for college costs.

The hardship distribution is limited to your postsecondary education expenses for the next 12 months. Eligible expenses include tuition and fees, as well as room-and-board at the college. A hardship distribution does not cover student loan payments or other college costs like books, bus fare, or academic club fees.

There are some significant drawbacks to the hardship distribution option:

  • The amount withdrawn cannot be repaid to the 401(k) plan. So if your financial situation changes, you cannot put the money back into your retirement plan.
  • You must suspend contributions for six months afterwards. If your employer matches your contribution, you will miss out on those contributions during the suspension period.
  • Because the hardship distribution is not a loan, it is subject to ordinary income taxes. You will have to report the hardship distribution as taxable income in the year of distribution.
  • If you are under the age of 59 1/2, you may also be required to pay a 10 percent early distribution penalty in addition to the income taxes.
  • You will lose compounding of earnings on the amount of the hardship distribution.
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