A Reader Asks #13: Paying for college with retirement funds
A recent comment asks:
"Art, how do 401(k) and IRA products stack up in the 'distribution for college tuition' category?"
I think there are a couple different facets to this question which have to be examined.
Tax Perspective – Money taken from tax qualified retirement plans are subject to income tax since the contributions have never been taxed. If you are younger than age 59 ½, then the distribution is considered premature and is generally also subject to a 10% penalty. However one of the exceptions to the penalty is distributions made to pay for qualified higher education expenses. Considering only the tax consequences, taking money out of a retirement plan to pay for college tuition is not a terrible choice. After all, the money was contributed pre-tax, had the chance to grow tax deferred, and is subject to ordinary income tax (without penalty) when withdrawn.
Alternative – Just because taking money out of a retirement plan is not a tax nightmare does not mean it is the best option. When it comes to retirement, the Roth IRA works best for most people. In both an IRA (and 401k) and a Roth IRA, money in the plan grows tax deferred. The difference is that with the Roth IRA you pay taxes on the contributions but receive money out of the plan tax free. With the IRA the contributions are made pre-taxes, but the distributions are taxable. Since the goal of these programs is to put in less money than you take out, it generally makes sense to pay taxes on the money you put in. When it comes to saving for college tuition there is a program similar in tax structure to the Roth IRA called 529 plans. Contributions to a 529 plan are not tax deductible but the money accrues tax deferred and withdrawals used to pay for college expenses are taken without paying taxes. If I were to choose between using an IRA or a 529 plan to pay for college, I'd choose a 529 every time.
The Bigger Picture – I'm a parent and I understand the desire to do whatever you can for your children. Yet as a financial planner I see clients repeatedly choose to fund their children's college education over their own retirement and I think that is a mistake. The government gives promising students who lack only the financial resources student loans, but no such programs are available to provide during retirement. I strongly suggest that before withdrawing money from a retirement plan or diverting contributions from retirement to a 529 plan, you should consider the impact. It is simply a matter of priorities.
Is there a financial topic you have a question about? Or is there something you have always wanted to know but were afraid to ask? This is your opportunity! Send me an email and ask your question. I will publish the answer here at the blog and promise to keep your identity confidential. No cost. No obligation. No strings attached.
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