Should I Use My 401(K) To Fund My Child's College Education?

Answer:

You can, but it isn't your best option. Your 401(k) plan should be dedicated primarily to your retirement

There are two primary drawbacks to using your 401(k) for college funding. First, if you withdraw funds from your 401(k) before you are 59½, you may owe a 10 percent premature distribution penalty on the withdrawal. This penalty is in addition to income taxes you will owe on the withdrawal*. Second, frequent dips into your 401(k) reduce the amount of money you ultimately have available to reap the benefits of compounding and tax deferral. This, in turn, reduces the overall funds for your retirement.

If you really need to use your 401(k) to pay for college, a better option might be to borrow from it if your plan allows loans. Plan loans are not taxed or penalized, as long as you repay the funds within a specified time period. But make sure you compare the cost of borrowing college funds from your plan with other finance options. Although interest rates on plan loans may be favorable, the amount you can borrow is limited, and you generally must repay the loan within five years. In addition, some plans require you to repay the loan immediately if you leave your job. Your retirement earnings will also suffer as a result of removing funds from a tax-deferred investment.

If you want to save for college in a retirement vehicle, consider using a traditional IRA or Roth IRA instead. With these IRAs, you will not owe the 10 percent premature distribution penalty on withdrawals you make before age 59½, as long as the money is used to pay your child's qualified college expenses. If you have some time to plan your child's college fund, you might consider a Coverdell education savings account (formerly called an education IRA) or a 529 qualified tuition plan established and maintained by a state or eligible educational institution**. Each of these vehicles is specifically geared to college investors and offers numerous tax advantages.

* In addition, company imposed surrender charges may apply to these withdrawals.

** Keep in mind that there are fees and charges associated with a 529 plan and the underlying investment options are subject to market risk and will fluctuate in value. In addition, 529 plans may not be protected from creditors. Prior to purchase or investment, please note that you may get more favorable tax benefits from 529 plans sponsored by your home state. Consult your tax advisor for how 529 treatments would apply to your particular situation.

GE 52196 (12/09)

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