Last-Ditch Ways To Fund College And Education Expenses

By: Eva Sadej

Coverdell ESAs (formerly known as Education IRAs) and 529 college savings plans are the best ways to fund education expenses, but they are not the only ways. If you find yourself and your family in a pickle when it comes to paying for education expenses, there are some alternative, last-ditch options. You can, if necessary, fund educational expenses through early withdrawals from your IRA and 401(k) without penalty. This article explains how these last-ditch options work.

Early Withdrawal From Your IRA

According to the IRS Publication 970, as long as you are under age 59 ½ and the student is attending college at least half-time, you can withdraw from your IRA funds to cover tuition, both graduate and undergraduate [1], room and board, fees, books, supplies, technological equipment such as a laptop and internet access for your home, and also computer software that is educational in nature. [2]. You can withdraw from an IRA to pay for educational expenses if you are a parent, spouse, grandparent, or the student him or herself (if the student already has an IRA in his or her own name, which is unlikely for undergraduates but may be more likely for graduate students). As a qualified individual, you can even withdraw money from your IRA for a student that is no longer a dependent. The school that the student will be attending can be private, public, or nonprofit as long as it is accredited by the Department of Education.

If you are withdrawing from a Traditional IRA, the withdrawal amount will be counted as taxable income the year you withdraw. If you are withdrawing earnings from a Roth IRA, you can do so tax-free up to the total amount of contributions if the earnings have been left in the account for five years or more (if the earnings are withdrawn prior to five years, they are included as income on your return and you are essentially double taxed as your contributions came from post-tax income as well). But be aware that withdrawing early from and IRA for educational expenses counts as income, whether taxable or tax-free, for the year and can harm the student’s financial aid eligibility.

Thus, an IRA can be used as a combined education and retirement vehicle. How much you can withdraw early from your IRA for education expenses, however, is not the total sum of your bill. To determine how much you can withdraw early, you must calculate your adjusted qualified education expenses. This is your total qualified education expenses (tuition, fees, books, supplies, equipment, room and board) minus any tax-free educational assistance (Pell Grant, scholarships, veterans educational assistance, employer provided educational assistance, and any expenses used to figure the tax-free portion of distributions from a Coverdell ESA.) [3]

Borrowing From Your 401(k)

You cannot withdraw funds early from a 401(k), but you can borrow against the balance of your account. Not all employers allow you to do this and they are certainly not obligated to. If your employer allows borrowing against the 401(k) plan, each year you can borrow up to $50,000 or half of the account value, whichever is lower. However, it’s very important to note that you cannot switch jobs for the duration of the loan. In addition, you cannot borrow against an old 401(k) at a company you are no longer working for. If you lose your job, either with voluntary or involuntary termination, you will be subject to a 10% early withdrawal penalty for the funds you borrowed if you do not repay the full balance of the loan plus interest within 60 days. [4]

The benefits of borrowing against your 401(k) are that you can get the loan quite quickly, usually within a week or so. Also you don’t have to qualify for the loan through a credit approval process because you are borrowing against your future retirement. 401(k) loans are generally paid off over a 5-year period via payroll deduction. Again, your employer and payroll provider have to support this functionality, so it’s worth asking before you make any concrete plans.

Alternatively, under the “hardship distribution,” you can take out all of your money from a 401(k) to pay for education expenses, but you will be charged the 10% federal penalty in addition to federal and state taxes on the amount, and you must go through a lengthy and embarrassing process of demonstrating financial need.

Our Recommendation

We recommend that you plan for college expenses of your children accordingly, making the best use of 529 plans and Coverdell ESA options, but if you have not done so and the time is nearing, you should consider these two options. Use the option of an early withdrawal from your IRA as your second to last option, and borrowing against your 401(k) as your absolute last resort.

And though it may lower your nest egg (not only by the amount you withdraw but also by the amount the earnings could have grown) some things, like financing your child’s education, have unquantifiable value.

[1] page 71-72