Pros and Cons of Withdrawing From a 401k to Pay for College

College can be a ticket to personal, financial, and career development, but it isn’t cheap. This leads many to consider tapping into retirement funds to pay for education. Doing so offers some advantages, but you risk compromising your financial security in retirement.

This article will examine some pros and cons of using your 401k or 401k rollover to pay for college and discuss alternatives.

Pros of Using a 401k to Pay for College

Tapping retirement assets for college costs can offer a few advantages over other funding sources:

Low Borrowing Costs

401k loans tend to have higher interest rates than Federal Stafford Loans (the main federal student loan type) but lower rates and fees than Federal Parent PLUS loans and private loans.

Thus, a 401k loan could reduce borrowing costs if you’re helping your child pay for college or going back to school yourself.

It Doesn’t Affect Need-Based Aid Determination

Borrowing from a 401k does not impact the student’s eligibility for need-based financial aid, such as federal student loans and grants. Thus, a 401k loan can help cover gaps if need-based assistance isn’t enough to pay for college.

Cons of Using a 401k to Pay for College

Drawing from your retirement funds for education can be risky. Here are some downsides:

Lost Investment Gains

Borrowing against your 401k reduces its balance, which leaves you with less money to compound, causing you to lose potential investment growth. A retirement calculator can illuminate how much growth you might lose if you borrow.

Furthermore, your plan may prevent new contributions until you finish repayment. Such restrictions further slow your progress toward retirement.

The Loan is Short-Term

401k plans that allow loans must restrict term lengths to five years. That’s half as long as the 10-year repayment most federal and private loans allow.

As a result, your monthly 401k loan repayment could be far higher. Plus, loan repayment starts immediately. Many federal loans don’t require repayment until six months after graduation.

Other Ways to Pay for College

Here are a few ways to cover college costs without drawing from your 401k:

1. College Savings Accounts

College savings accounts offer tax advantages when saving for college. This helps you keep more of the money you need to cover college costs.

The 529 college savings plan is the most well-known. These state-run plans let you contribute after-tax funds and invest in various securities. Investments grow tax-deferred.

Withdrawals are tax-free if spent on qualified higher education expenses, such as tuition.

Forty-nine states and Washington, DC, have 529 college savings plans. Many states don’t require residency to invest in theirs. There are no annual contribution limits, but plans may have lifetime maximums ranging from $235,000 to $500,000.

2. Scholarships and Grants

Scholarships and grants are free college money you do not have to pay back.

Grants are need-based, meaning you can win them based on your financial situation. Start with these to max out need-based aid.

Scholarships are merit-based, meaning financial need is not the primary consideration. There are tons of scholarships for students of all kinds, from small and simple awards to massive scholarships with more rigorous applications. Your scholarship aid potential is theoretically unlimited, so pursue them after grants.

3. Student Loans

Federal student loans have lower interest rates than private loans. Plus, they offer deferment, forbearance, income-based repayment plans, and loan forgiveness for specific careers.

Some federal loans don’t accrue interest or require repayment until six months after graduation. Others do accrue interest but don’t require repayment until that grace period ends.

Private loans should be a last resort — they require a credit check, have higher interest rates, fewer debt relief options, and require payments immediately. 401k loans may work better than private loans in some cases.

The Bottom Line

Using a 401k loan comes down to return on investment and your retirement preferences.

If you’re returning to school for career advancement, forecast your potential earnings boost to see if it outweighs the financial costs of borrowing. If you’re using a 401k loan to pay for your children’s education, ensure it doesn’t compromise your retirement goals.

Pursue other options first — particularly non-loan methods to minimize debt. Start a college savings account as early as possible. Apply for as many grants and scholarships as you can.

Only after exhausting these should you pursue student loans. Start with federal loans. If you still have college costs after all of these, a 401k loan may help cover the difference. Hopefully, you won’t need to borrow as much so that you can preserve your retirement savings.

Sources:

https://educationdata.org/average-cost-of-college

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-loans#:~:text=Repayment%20of%20the%20loan%20must,are%20paid%20at%20least%20quarterly.

https://www.savingforcollege.com/article/how-much-can-you-contribute-to-a-529-plan#sfc-page-anchor-4