Parents want to know pros and cons of paying for 21-year-old son’s college with their 401(k) – Money Matters

Q. Our 21-year-old son has now decided that he wants to go to college. We are very happy about this but we already gave him the money we had saved for his college expenses. We invested in a business idea he had and it didn’t work out. He is our only child so helping him with his college expenses is not up for discussion (no lectures please) but we need to figure out the best way to come up with the money. We are thinking about taking a hardship withdrawal from our current 401(k) plans and/or from previous employer 401(k)s. We are both under 59 ½ but I’ve heard that the 10 percent early withdrawal penalty is waived for college expenses. What are the pros and cons of using our 401(k)?

A. If you can qualify for a hardship withdrawal and the plan allows for such withdrawal, you will owe income taxes and a 10 percent penalty since you are under age 59 ½ on the amounts withdrawn. The 10 percent IRS early withdrawal penalty may be waived for catastrophic illness but not for college tuition. Since the amount you withdraw will be added to your taxable income this action could put you in a higher income tax bracket.

You can qualify for a hardship withdrawal if you can demonstrate an immediate and heavy need for the following reasons: un-reimbursed medical expenses for yourself or dependents, down payment of a primary residence, college tuition for yourself or a dependent (that’s due in the next 12 months), and saving your home from eviction or foreclosure.

The IRS requires that you borrow from your 401(k) before you can take a hardship withdrawal. Typically, you can borrow half the funds in your account up to $50,000. You must pay it back within five years. If you leave the company for any reason you must pay off the loan in full or this amount will be subject to the same taxes and penalties as a withdraw.

You can avoid the 10 percent penalty on the funds in your former employer’s 401(k) plan by rolling it to an IRA before beginning withdrawals. Beginning in 1998, withdrawals from an IRA that are used for qualified higher educational expenses (tuition, fees, books and supplies) are not subject to the 10 percent penalty for early withdrawal prior to age 59 ½. The withdrawal cannot exceed the post-secondary education expenses for the year in which the withdrawal is made. You will still pay regular income tax on the distribution.

Other possibilities should be reviewed before taking money from your retirement funds. Student loans, financial aid and taping into your home equity may be a better financial decision rather than raiding your retirement accounts. Your retirement funds would be left to grow tax-deferred and the interest on the education or home equity loan may be tax-deductible.