Parents of college students are now less likely to withdraw money from their retirement accounts to pay for college. Only 5 percent of families took a retirement account distribution for college costs in 2016, down from 7 percent in 2014, according to a Sallie Mae and Ipsos survey of 799 parents of undergraduate college students. The average amount of the withdrawal also dropped from $8,870 in 2014 to $4,814 in 2016.
Early withdrawals from retirement accounts can result in taxes and penalties that will reduce your retirement savings and your ability to pay for college. Here’s a look at what happens when you use distributions from various types of retirement accounts for higher education expenses.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
IRA withdrawal. IRA withdrawals before age 59 ½ typically trigger a 10 percent penalty. But you don’t have to pay the early withdrawal penalty on an IRA distribution if you use the money for higher education expenses for yourself, your spouse or your children or grandchildren. Qualifying expenses include tuition, fees, books, supplies and equipment required to attend a higher education program that participates in the federal student aid program. Room and board are also eligible expenses for full-time students.
However, although you can avoid the 10 percent penalty, you may still owe income tax on the distribution. A worker in the 25 percent tax bracket who withdraws $10,000 from his IRA will increase his tax bill by $2,500. Also, withdrawals from traditional IRAs are considered income, which could impact eligibility for federal financial aid.
Roth IRA distribution. Roth IRAs provide easier access to your money before retirement. For an early Roth IRA distribution, you will owe income tax only on any portion of the withdrawal that comes from investment earnings. Roth IRAs allow you to withdraw your nontaxable contributions before your taxable earnings, so if you withdraw less than the amount you contributed to the account you can avoid income tax on the distribution. Roth IRAs also have the same exception to the early withdrawal penalty as traditional IRAs when the money is used for qualifying higher education expenses. And if you are over age 59 ½ and the Roth IRA is at least 5 years old you can take tax and penalty-free withdrawals.
[See: 10 Reasons to Save for Retirement in a Roth IRA.]
401(k) withdrawal. 401(k) distributions can also be used to pay for college, but they will be subject to income tax and a 10 percent early withdrawal penalty if you’re under age 59 ½. A family in the 25 percent tax bracket that withdraws $10,000 from a 401(k) before age 59 ½ will trigger $3,500 in taxes and penalties. You might also be prohibited from contributing to the 401(k) plan for six months after the distribution, which can make it especially difficult to begin rebuilding your retirement account balance. Like an IRA distribution, a traditional 401(k) withdrawal is considered income and will impact your future eligibility for financial aid.
401(k) loan. Retirement account loans aren’t an especially popular way to pay for college. Fewer than 1 percent of families took a retirement account loan to finance higher education costs, but those who did borrowed an average of $5,765 in 2016, Sallie Mae found. Retirement savers are often eligible to borrow as much as 50 percent of their vested 401(k) account balance up to $50,000. A 401(k) loan allows you to pay yourself back with interest and avoid the tax consequences of a retirement account withdrawal.
Loans for college costs must be paid back within five years. However, if you leave your current job, the loan could become due at that time. If the loan isn’t repaid, the outstanding balance is considered a distribution and taxes and penalties will be applied. 401(k) loans also charge a variety of fees, including origination, administration and maintenance fees. Consider comparing the terms of a 401(k) loan to other loans you might be eligible for, such as federal PLUS loans, home equity loans and private education loans.
[Read: How to Pay Less Taxes on Retirement Account Withdrawals.]
Money withdrawn from retirement accounts paid for approximately 2 percent of total college expenses for the 2015 and 2016 academic year, according to Sallie Mae estimates. Other types of parent savings, such as 529 college savings plans, paid for 9 percent of college costs. Some parents used both a retirement account and a 529 plan to pay for college.
Emily Brandon is the author of “Pensionless: The 10-Step Solution for a Stress-Free Retirement.”
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Fewer Families Use Retirement Accounts to Pay for College originally appeared on usnews.com
