Is it OK to Raid My 401(k)?

8265139231_3bcf9c8a26Image source: Chris Potter

Last week, we discussed the challenges that parents are facing when it comes to putting their kids through college while the cost of tuition has risen and continues to rise to astronomical heights.

Without careful planning years before your child(ren) even begin to think about applying to college, you could conceivably find yourself between the proverbial rock and a hard place when it comes to financing four years (and sometimes more) of continuing education. In a quandary, you may take a look at all the money you’ve saved for your upcoming retirement and wonder if you could or should borrow from one or more of those accounts – in particular, your 401(k).

Our general advice to parents who are contemplating borrowing money from their 401(k) in order to give their child a fully or at least partially funded college education is this: Back away from the 401(k). The risks associated with filching your own retirement funds include: money in your 401(k) is tax-sheltered, however, when you pay back what you borrow, you must use after-tax money. Sure, you have 12 months to pay back any money borrowed without a penalty, however, if you lose your job or leave by choice, any 401(k) loans that you have taken must be paid back immediately. If you fail to do so, you’ll be charged income tax on the remaining amount you owe, plus a 10% penalty fee.

With all of the above being said, we feel that giving blanket answers to financial questions isn’t very accurate, even regarding taking a retirement loan. So, YES, there is a case to be made for tapping into your 401(k) account, in very specific circumstances.

If you can confidently say that you are totally secure in your retirement and that you don’t actually need the money provided by your 401(k) or IRA, it could be a smart move for you to use some of that money to pay for your child’s or grandchild’s college tuition.

Another circumstance: if you happen to fall into a tax bracket that charges zero percent because you have high medical costs, distributing some of your retirement money now is probably a good idea for you and your loved ones. Wondering why? Simple – it’s better to share the wealth while you are in a zero percent tax bracket instead of gifting the money through your Last Will and Testament because it’s unlikely that your beneficiaries will be in the zero percent tax bracket at the time of your passing. In fact, some may fall into the fifty percent bracket if they had great schooling and pursued a high paying career. Naturally, because of the higher taxes they’ll have to pay, they will receive significantly less of your hard earned savings. Better to use the money now while you can get more bang for your buck.

Even if you are in a fantastically secure financial position regarding retirement, there are still better ways to help your child or grandchild pay for college than dipping into your retirement accounts, just in case things change drastically. Since retirement brings with it many uncertainties, it’s still a good idea to have your (grand)child take out some student loans. As long as the child remains in school, offer to pay for the interest on the loan. This will drastically lower the amount of accrued interest on the loan(s). After graduation, you can assist with loan payback, as long as your retirement outlook is very bright. In that situation, though, it would still be better if you were using income other than your retirement fund to help out.

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