Q: Our daughter has been accepted to a wonderful but expensive 4-year private college. She has her heart set on attending this college, but our college savings was geared toward a public university. We have close to $60,000 in a 529 plan, but that will only cover three semesters at the private college. We don’t want her to have any debt when she graduates and, if necessary, are willing to work longer and delay retirement. We have some IRAs and retirement plans and understand this money can be used for higher education without any penalty even though we are under age 59 ½. Do we just move this money into the 529 plan? No! One of the exceptions to the 10 percent penalty for taking an early distribution, before age 59 ½, from an IRA is if the withdrawal is used to pay for qualified higher education expenses on behalf of you, your spouse, or the children or grandchildren of you or your spouse. This must be paid to an eligible educational institution. If you put the money in the 529 plan first and then use the funds to pay for college, you haven’t met the definition of the exception even though the funds were ultimately used for education. The IRS definition of an eligible education institution is: any college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the U.S. Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible institution. The IRS definition of a qualified higher education expense is: tuition, fees, books, supplies and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. If the individual is at least a half-time student, room and board are also qualified higher education expenses.
The 10 percent penalty from an early distribution from a qualified retirement plan such as a 401(k) or 403(b) doesn’t apply if the distribution meets one of the following exceptions: distributions upon the death or disability of the plan participant, you were age 55 or over and you retired or left your job, you received the distribution as part of substantially equal payments over your lifetime, you paid for medical expenses exceeding 7.5 percent of your adjusted gross income or the distributions were required by a divorce decree or separation agreement. The qualified education exception is only for IRAs. You could borrow the lesser of $50,000 or 50 percent from a qualified plan in which you are an active participant. Unless you use the money to purchase a home, the loan must be repaid within five years. If you terminate employment for any reason, the loan will usually need to be paid back within 60 days. If you are unable to repay the loan, it will be deemed a distribution and likely subject to federal and state taxes as well as the 10 percent penalty for an early distribution. You will pay interest on the loan, but the interest is paid to yourself. The loan is paid back with after-tax dollars, and until the loan is repaid, you will not be investing for your retirement.
I would not recommend borrowing from a qualified retirement plan unless it was for a financial emergency. I would recommend that you visit with a financial adviser and determine exactly how funding 100 percent of your daughter’s education will impact your retirement planning. What happens if you spend the money on her college and then lose your jobs for some reason, including illness or disability? Offering to help with repayment of student loans as your cash flow allows once she graduates makes more sense to me.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624