College living expenses and tuition have increased in recent years, making it difficult to cover higher-education costs with a traditional college savings plan. It's sometimes possible to borrow from retirement funds to pay for college. If you are thinking about doing that, learn the tax consequences associated with distributions from an individual retirement account and other types of retirement plans, and also know any early-withdrawal penalties.
If you withdraw funds from a traditional or Roth individual retirement account before age 59 1/2, the transaction is usually subject to a 10 percent early-withdrawal penalty. An exception exists for withdrawals used for qualified higher-education expenses -- such as tuition, fees, books -- for you, your spouse, your children or grandchildren. In that case, the only consequence for withdrawing money from a traditional or Roth IRA to pay for college expenses is the need to pay income tax on the withdrawal.
If you hold a 401(k), you might be able to borrow up to 50 percent of your plan's value or up to $50,000, whichever is less. The loan is repayable over five years. The advantage to borrowing is that you can pay the money back and avoid taxes and penalties. But if you leave your job, any unpaid loan balance is considered a withdrawal subject to taxes and early-withdrawal penalties.
Some retirement plans permit account holders to request a hardship withdrawal. Such a withdrawal is subject to a 10 percent penalty if you’re younger than 59 1/2. And it might restrict contributions to your plan for as long as six months, which could mean also missing the employer contribution. You also would have to show that you had exhausted all other financial resources.
Financial Aid Considerations
Withdrawing money from your retirement plan can hurt the student's financial aid package. When you withdraw from a traditional IRA, a Roth IRA or a 401(k), you must declare the withdrawal as income on your tax return. This increases your adjusted gross income -- the figure used to calculate financial aid packages for students. That could reduce the total financial aid the student will receive from a college in future years.
Future Retirement Income
Borrowing against or withdrawing money from from a retirement plan has consequences for your retirement security. Once money has been withdrawn from an IRA, the only way to replenish the IRA is through normal contributions, which are subject to yearly limits.
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