Paying for college with your 401(k)

Tapping your nest egg to pay for your kid's education is one financing option you should carefully consider.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I will soon have three kids in college at the same time. I've set aside some money for college education, but not enough. I'm figuring I'll have to tap my 401(k) at work, but am unsure how much I can take out and how best to do it. Any advice? - Rick, Naperville, Illinois

Answer: I'm not at all surprised that you were unable to set aside enough money to pay three college tuitions simultaneously. With the annual cost of tuition, fees, room and board running just under $13,000 a year at a four-year public university and a bit more than $30,000 at a private college, you'd have to be earning some mighty big bucks to be able to save for retirement (which, in my opinion, should be the first priority) and sock away enough to foot the bill for your kids' foray into the hallowed halls of academe.

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All of which is to say that I think lots of parents find themselves in your position: a bit of cash stashed away for education, some money in a 401(k) and a natural tendency to want to do all they can financially to make sure their kids get the best education possible.

So let's take a look at what your options are. I'll start with what you're most interested in - tapping your 401(k) - even though I don't think that's necessarily the best way to go.

Borrower beware!

When it comes to getting money for your kids' education from your 401(k) plan at work, your first option is to take a 401(k) loan. Your 401(k) plan isn't required to make loans, but about 85 percent or so of plans do offer them.

Generally, you can borrow up to $50,000 or half your account balance, whichever is less, and you have up to five years to repay the loan, usually through payroll deductions. Interest rates vary from plan to plan, but a typical charge is the prime rate (now 8.25 percent) plus one percentage point.

The loan proceeds aren't taxable, but, of course, you do have to repay the loan with interest (which, by the way, is not tax deductible). And while the interest does go into your 401(k) account, it's possible that the interest rate you're paying may be less than what those funds would have earned if they'd remain invested in the plan, in which case your 401(k) balance at retirement will be lower than it otherwise would have been.

Another caveat: If you switch jobs, the loan must be paid back right away, typically within 60 days of the time you leave. If you don't have the cash to pay off the loan, then the loan balance will be considered a taxable distribution, which means you would owe tax plus a 10 percent penalty, assuming you're under age 55.

A last resort

There is another way to get money out of your workplace 401(k), but it's no cinch. You can apply for a hardship withdrawal. Again, the plan doesn't have to offer this option, although about 95 percent of plans do.

But getting a hardship withdrawal isn't just a simple matter of saying you're financially pressed and could use the money. IRS rules stipulate that you must demonstrate "an immediate and heavy" financial need. There are several situations that may qualify for a hardship withdrawal, and paying tuition and related educational fees is indeed one.

That said, the rules also state that the distribution must be necessary to satisfy that financial need and that you have no other way of meeting it. In other words, you cannot get a hardship withdrawal if there are other resources you can access to pay your kids' college bills, such as other investments or a home equity loan. As a practical matter this may also mean that if your plan allows loans, you would first have to exhaust that option before you could apply for a hardship withdrawal.

The size of a hardship withdrawal is generally limited to the amount you've contributed to the plan, although in some cases you may be able to get funds your employer kicked in. The withdrawal is taxable and subject to the 10 percent early-withdrawal penalty as well, which can really whittle down how much you'll have left to apply to college expenses. (There are some instances where the penalty is waived, but education expenses don't qualify. For details on rules and regulations surrounding hardship withdrawals, click here.) You'll probably have to apply in writing for a hardship withdrawal and your employer will decide whether you qualify.

All in all, a hardship withdrawal should be considered a last resort. Not only because you may not qualify, but because it can seriously derail your retirement prospects. With a loan, at least you're putting the money you borrowed plus interest back into your account. You're not allowed to restore hardship withdrawal funds, however. So that money, plus whatever it would have earned, is lost as far as your retirement is concerned.

Clearly, then, a 401(k) loan is a much more viable option than a hardship withdrawal. But I still think you should investigate other options before digging into your 401(k).

Smarter options

At the very least, you'll want to check out as many sources of financial aid as you can, a search you can begin by clicking here and here. After all, if your kids' qualify for even some scholarship or grant money, that can lighten the load that you'll have to carry.

While you're at it, look into college loans. And I'm not just talking about loans that are made to parents. There's no harm in having your kids take on a reasonable amount debt to finance their education. It might even make them more dedicated students knowing they're paying part of the tab, and it could motivate them to take charge of their financial lives quickly after graduation as well.

And if you own a home, there's always the possibility of taking out a home equity loan or line of credit. That would have the advantage of most likely making the interest tax deductible, which isn't the case for a 401(k) loan. (Interest on student loans may also be tax deductible. You can check out IRS Publication 970: Tax Benefits for Education for the particulars. This publication also details other tax goodies, like Hope and Lifetime Learning Tax Credits.)

In general, I think you're better off if you can find other ways of financing your kids' education-including having them share some of the burden-than tapping your 401(k). But if it turns out that for whatever reason the old retirement nest egg is really your best option, well, at least you now know how to go about it.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.