Top five problems when using your 401k to pay for college



2.) Taxes and penalties.  There are two options for getting money out of your 401k: a loan to yourself, and a hardship withdrawal. There is a significant cost to using a hardship withdrawal. Withdrawing $10,000 from a 401k will not equal $10,000 to spend on college tuition. You can plan on losing 35-45 percent of the withdrawal to taxes and penalties, assuming you are under 59½ . For example: If you are in the 28 percent tax bracket and, instead of a loan, you take a hardship withdrawal of $25,000 to pay for your child's college tuition, you will owe $7,000 in federal income tax and an additional $2,500 to cover the 10% early withdrawal penalty. That leaves just $15,500, or even less if you owe state and local income tax.

3.) It’s not enough money. The amount available to borrow probably won’t be enough to cover the cost of college.  The price of college is increasing faster than inflation. If you include tuition, room and board, and fees a 4-year public university costs about $25,000 a year. Private schools cost about $50,000 a year or more. Generally, you can borrow up to $50,000 or half the account value of your 401k, whichever is lower. It seems like a lot, but $50,000 probably won’t cover the full cost of college.

4.) Changing jobs becomes expensive. If you take out a loan from your 401k and then switch jobs, you must pay the loan back right away. Typically, it must be paid back within 60 days from the time you leave the old job. If you can’t pay back the loan within 60 days then the money withdrawn from the 401k changes from a loan to a taxable distribution, which means, assuming you're under 55, you now owe income tax on the amount plus a 10 percent penalty. Ouch!

5.) Reduced earning power. If you don’t change jobs after taking out a 401k loan then the loan amount is not taxable. But you do have to repay the loan with interest.  Even though you are paying yourself interest, which goes back into your 401k, you’d probably make more on the money if had stayed in the 401k account. The interest rate paid on 401k loans is the prime rate plus 1-2 extra percentage points and is often less than the rate the money would have earned if had remained in the account, which means your retirement funds will be lower than it otherwise would have been.

1.) You’re not allowed. Your 401k plan isn't required to give a loan to you. Most plans do make loans, about 85% of plans, but the remainder don’t. Find out from your employer’s Human Resources department if your 401k plan has the loan option.

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