Paying for college can be a financial challenge, leading many families to explore unconventional options like using retirement savings. While tapping into a retirement account such as a 403(b), 401(k), or IRA might seem like a quick solution, it’s essential to understand the rules, benefits, and potential downsides.
This article explores how you can use a 403(b) or other retirement plans to cover college expenses, what to consider before withdrawing funds, and alternative strategies that may better preserve your financial future.
403(b) and 401(k) Retirement Plan Loans
Employees can borrow money from their 401(k) and 403(b) retirement plans if they offer retirement plan loans. IRAs are not eligible.
You can get a retirement plan loan for any purpose, including higher education expenses.
The aggregate loan limit is $50,000 or half the vested balance in the retirement plans, whichever is less. If the vest balance is less than $10,000, the aggregate limit is $10,000.
The repayment term is 5 years or when the employee loses their job, whichever comes first.
The IRS will treat the remaining loan balance as a distribution if the employee does not repay the plan loan within the repayment term.
Most employer plans suspend contributions to the retirement plan until you repay the retirement plan loan in full. This can cause the employee to miss the employer match on contributions to the retirement plan.
Employees should consider borrowing from federal student and parent loans before turning to a retirement plan loan. Although the interest paid on a retirement plan loan is added to the employee’s retirement savings, this merely replaces the income the retirement plan would have earned if the money had remained invested in the retirement plan.
Hardship Distributions from 403(b) and 401(k)
Hardship withdrawals you make from a 401(k) or 403(b) retirement plan to pay for college tuition, fees, room and board during the next 12 months. 457(b) retirement plans are not eligible.
Hardship distributions are subject to income tax. If the account owner has not yet reached age 59-1/2, the hardship distribution will also be subject to a 10% tax penalty.
The CARES Act waived the 10% tax penalty for hardship distributions made in 2020 and increased the limit to $100,000 in certain circumstances related to the pandemic. However, this provision is no longer in effect.
Rolling Over a 403(b) or 401(k) into an IRA
Former employees can roll over a 401(k) or 403(b) retirement plan into an IRA and then take an early distribution to pay for college.
A hardship distribution from a 401(k) or 403(b) is limited to tuition, fees, room, and board and may be subject to the 10% tax penalty if the taxpayer hasn’t yet reached age 59-1/2.
An early distribution from an IRA has a broader set of qualified expenses and avoids the 10% tax penalty.
So, rolling over a 401(k) or 403(b) retirement plan into an IRA is a better option for using a retirement plan to pay for college costs. Remember that some employer plans may not allow rollovers while employed and actively participating.
Early Distributions from an IRA
Early distributions from an Individual Retirement Account (IRA) are subject to a 10% tax penalty if the account owner has not reached age 59 1/2.
Early distributions to pay for qualified higher education expenses at a Title IV college or university eligible for federal student aid are exempt from the 10% early withdrawal penalty. However, the IRS will tax distribution as ordinary income.
The tax penalty waiver applies to all IRAs, including traditional and Roth IRAs, as well as SEP and SIMPLE plans. 401(k) and 403(b) plans are not eligible.
Qualified higher education expenses for a Roth IRA distribution include the same expenses as for 529 college savings plans. They include tuition, fees, books, supplies, equipment, special needs expenses, and room and board (if the student is enrolled at least half-time). However, they do not include K-12 tuition or student loan repayment.
The early distributions are limited to paying for the qualified higher education expenses of the taxpayer, spouse, children, and grandchildren, including adopted and foster children.
Tax-free Return of Contributions from a Roth IRA
Contributions to a Roth IRA are made with after-tax dollars, and qualified distributions are entirely tax-free.
A return of contributions from a Roth IRA is tax and penalty-free even if the account owner has not yet reached age 59-1/2. Thus, a tax-free return of contributions from a Roth IRA can be used to pay for college, repay student loans, or any other purpose.
However, a tax-free return of contributions from a Roth IRA is reported as untaxed income on the Free Application for Federal Student Aid (FAFSA). As much as half of the distribution will reduce eligibility for need-based financial aid.
However, given that the FAFSA uses prior-prior year income, Roth IRA distributions that occur on or after January 1 of the student’s sophomore year in college will not be reported on the FAFSA, assuming that the student graduates from college in four years. If the student will graduate in five years, distributions should be made on or after January 1 of the junior year in college. The safest solution is to wait until the student graduates from college and to use a tax-free return of contributions from the Roth IRA to pay down student loan debt.
Is a Roth IRA conversion counted as income on the FAFSA?
Converting a traditional IRA into a Roth IRA will result in taxable income included in the student’s adjusted gross income (AGI). This increased income will affect the student’s eligibility for need-based financial aid.
However, the student or parents can appeal to the college financial aid office to have the exclusion removed from the income on the FAFSA.
Use our Financial Aid Calculator to estimate the expected family contribution (EFC) and your financial need.
The U.S. Department of Education issued Dear Colleague Letter GEN-99-10 in February 1999 to encourage colleges to use professional judgment to reduce income and taxes associated with a Roth IRA conversion. The letter notes that a Roth IRA conversion does not provide the family with additional income for college.
Hardship Distributions Do Not Affect QHEE for 529 Plans
A coronavirus-related hardship distribution from a 401(k) plan under the CARES Act does not reduce qualified higher education expenses for qualified distributions from a 529 plan.
Tax-free educational assistance, such as the tax-free portion of a grant, scholarship, or fellowship, veterans’ educational assistance, and employer-paid educational assistance, reduces qualified higher education expenses (QHEE).
Coordination restrictions exist with the American Opportunity Tax Credit (AOTC) and Lifetime Learning Tax Credit (LLTC), which effectively reduce qualified higher education expenses by the amount of qualified higher education expenses used to justify the AOTC or LLTC.
