Borrowing from a 401(k) to Pay For College: Wise Move or Bad Choice?

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 retirement. Borrowing from your 401(k) might ease immediate financial pressure, but it can also cause stress about whether you’ll have enough for retirement.

However, a 401(k) loan might be viable for you under certain circumstances. In other cases, it may be the only option.

You’re committed to helping your child achieve their college dreams, but what if traditional funding options through FAFSA, including financial aid and student loans, aren’t enough? Could tapping into your 401(k) be a last resort solution, or will it jeopardize your retirement security? There are more drawbacks than benefits to using your 401(k) in any form to finance your child’s college education. Here’s what to consider.

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 federal student loans. The interest rate on a 401(k) loan is typically the Prime Lending Rate plus one percent, which is often lower than the interest rate on a Federal Parent PLUS Loan but higher than the interest rate on a Federal Direct Loan.
• A 401(k) loan does not involve any fees. In contrast, Federal Parent PLUS loans have fees over 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 a 401(k) loan repayment 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 it. You might feel more comfortable borrowing from yourself than from strangers.

While borrowing from a 401(k) might make sense in certain circumstances, these situations should be carefully evaluated against the potential drawbacks.

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 to pay 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 cannot repay the loan and 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 merely replaces the income you would have received had you left the money invested in the retirement account.
• 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

Alternatively, to a 401(k) loan, you might take a hardship withdrawal 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 college tuition, fees, and room and board at the college. A hardship distribution does not cover student loan payments or other college expenses 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 return the money to 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 withdrawal penalty in addition to the income taxes.
• You will lose compounding of earnings on the amount of the hardship distribution.

What to do before you borrow from your 401(k)

Before borrowing from your 401(k), consider these steps:

1. Explore federal and private student loan options. The rates could be similar to or even better than a 401(k) loan, and student loans won’t directly impact your retirement savings.
2. Consider other funding sources. Other funding sources, such as Roth IRA contributions, personal loans, home equity loans, employer-sponsored tuition assistance, part-time student employment, and more, are options if student loans aren’t enough. Be aware of the pros and cons of these options, too.
3. Calculate how much borrowing will impact your retirement. Do the math to see what the impact will be.
4. Consult a financial advisor to understand tax implications and long-term effects. Using and calculating the impact of 401(k) loans can be complicated. Getting professional help ensures you’re making the right choices.

Borrowing from your 401(k) to fund college should typically be seen as a last resort. Exploring other options first and understanding the long-term impact on your retirement will help you make the best financial decision for your family.