Find ways to help kids without risking your safety net
Conventional wisdom suggests, as do prudent advisers, that you should never, ever raid your retirement accounts to pay for your children’s or grandchildren’s college costs.
After all, you or your children can borrow money to pay for school; you can’t do the same when it comes to your retirement. But as parents of college-age children look at the financial aid packages now arriving in their mailboxes, and as these very same parents look at their first quarter balances in their 401(k) and IRA accounts, it would be hard not to ask the question: Are there times when it makes sense to raid your retirement account to pay for college?
Generally the answer is no. “The problems with using retirement accounts to pay for a child’s or a grandchild’s education are real,” said David Mendels, director of planning at Creative Financial Concepts. For starters, he said most of us have inadequate retirement savings and can ill afford to use them to pay for anything other than their intended purpose.
Others are of the same opinion. “My initial advice would be ‘don’t do it!’ but blanket statements are dangerous,” said C.E. Scott Brewster of Brewster Financial Planning.
So what then are exceptions to the rule?
Are you 100% funded?
Well, in rare instances it might make sense as part of an overall plan. “If someone was 100% secure in their own retirement and did not need the money they might then use some of their IRAs or 401(k)s to pay for their children or more likely grandchildren’s college costs,” said Brewster.
He noted, for instance, that many grandparents pay no taxes at all because they have high medical costs that as a tax deduction wipe out any taxable income they have. “Those grandparents in a 0% tax bracket might find distributing some money from their retirement plans is a very wise thing to do,” said Brewster. “Better to distribute it when you are in a 0% tax bracket to pay [for] grandkids’ college or grad school than leave the IRA or 401(k) to your grandkids when you die and then when they take the money out the grandkids could be in a 50% tax bracket—federal and state—if they, because of great schooling, became a doctor or lawyer or other high-income professional.”
The bottom line, said Brewster, is if you take money out of IRAs and 401(k)s, make sure you have a plan and know why it is an intelligent thing to do.
Pay interest on college loans instead of raiding retirement accounts
Others agree that it makes sense to raid your retirement accounts, but only under rare conditions.
“The only exception would be if someone’s retirement account was so well funded and they were absolutely certain that the market was not going to go south in their lifetime and they know they will never outlive their retirement savings,” said L. Ann Coulson, an assistant professor at Kansas State University. “Then raiding retirement funds would be fine.”
The only problem is that it is unlikely that any of that would happen. “The reality is that there are too many uncertainties with retirement and retirement savings,” said Coulson.
Others note that raiding one’s retirement account leaves one little time to make up for any distributions. “The older you are, the less time you have to make up for the loss,” said Rosilyn Overton, an associate professor at New Jersey City University.
To be fair, Coulson said, there are ways for parents to help their children or grandparents to help grandchildren pay for college costs without putting their own retirement at risk “If they truly want to help their children/grandchildren, let the child borrow conventional student loans and then the parent/grandparent can pay the interest costs on the loans while the child is in school—that way interest is not accruing on interest,” she said.
Then once the child has graduated, if the parent is feeling fairly confident about retirement savings, they can help the child pay the loans off. But, Coulson noted, that should she would be much more comfortable if they used current income rather than retirement funds to do that.
Others also recommend that tactic and give permission to use retirement funds to pay back college loans. “Generally speaking, it is preferable to allow the child to take out loans and then, if need be, help the child to pay them off—even if that meant dipping into retirement savings at a later date,” said Mendels.
Other exceptions to the rule
Overton also agrees it doesn’t usually pay to raid retirement accounts to pay for college costs. But there are exceptions to the rule.
For instance, if there is a cash flow problem—such as tuition is due and you won’t have the funds until next month—and you can replace the funds within 60 days, then no harm done. “You must be disciplined enough to actually pay it back within the 60 days,” Overton said.
Another exception is this: If you have low income this year, you have exhausted all financial aid and scholarship opportunities, your child or grandchild has does his or her part by working, and the withdrawal won’t push you into a higher income-tax bracket.
Overton also said it might make sense to raid retirement accounts provided you don’t adversely affect the child’s eligibility for financial aid or scholarships. “Since retirement plan distributions will increase a parent’s income they may end up reducing the financial aid available and so end up being of little net benefit and at great net cost,” said Mendels.
Avoid the 10% penalty
If you do plan to raid your IRA to pay for college, consider this: Uncle Sam may cut you some slack. Generally, if you take a distribution from your IRA before you reach age 59½, you must pay a 10% additional tax on the early distribution, according to the IRS.
This applies to any IRA you own, whether it is a traditional IRA (including a SEP-IRA), a Roth IRA, or a SIMPLE IRA. What’s more, the additional tax on an early distribution from a SIMPLE IRA may be as high as 25%. However, you can take distributions from your IRAs for qualified higher education expenses without having to pay the 10% additional tax, according to the IRS.
True, you may owe income tax on at least part of the amount distributed, but you may not have to pay the 10% additional tax, says Uncle Sam.
Note, too, that there are procedures to follow to show that the withdrawal is for qualified educational expenses, so it pays to work with a professional adviser. Generally, according to the IRS website, if the taxable part of the distribution is less than or equal to the adjusted qualified education expenses (AQEE), none of the distribution is subject to the additional tax. If the taxable part of the distribution is more than the AQEE, only the excess is subject to the additional tax.
All the details can be found at Education Exception to Additional Tax on Early IRA Distributions.
Overton suggests that if you have made after-tax contributions to your IRA, withdraw these first. As an aside, Overton also said it is always best to put after-tax contributions to an IRA in an account separate from your pretax IRA so that it is clear which funds are which.
In the main, however, Mendels noted that retirement accounts are generally far less effective for funding college because they are taxable. For instance, withdrawals from retirement plans other than IRAs may not even be available and would be subject to an additional 10% early withdrawal penalty.
Education expenses—as noted—are penalty exempt for IRAs, but not qualified plans.
Conventional advice revisited
“The conventional wisdom is not unfounded, but not infallible either,” Mendels said.
He noted, for instance, that the problems with using retirement distributions do need to be understood and not every child needs to or ought to go to college. “Still, if my child or grandchild were faced with the prospect of not being able to attend college at all, or not being able to attend a college that was clearly the better choice for him or her, would I ‘never’ consider using retirement savings?” he asked. “I can’t say that.”
As a financial planner, Mendels said he would have to consider its impact on his own retirement plans, though he noted that we do “make sacrifices” for our children.
“At that point, it would come down to a matter of priorities which would be a deeply personal decision,” he said. “Would I encourage a client to do it? No. Would I discourage a client from doing it? That is really not my place or my job. My job is to help my clients to make informed decisions, not to make the decisions for them. I would help them understand the consequences, but the choice would be and ought to be theirs.”
Robert Powell is a featured writer on the MarketWatch Retirement blog, a Research Fellow at the California Institute of Finance, and a Featured Contributor here on the CIF blog.