With the cost of attending a four-year college easily inching into the six figures these days, you might be tempted to dip into your retirement savings to help cover your child's education. But by doing so, you could be making a costly mistake.
Not only are you reducing your account balance, but you are also missing out on the compound returns those funds will gain over time -- putting your overall retirement savings at risk.
"You can borrow money for college, but it's very difficult for a retiree to borrow money for retirement," said Tash Elwyn, president of the Private Client Group at Raymond James, a financial advising firm.
Ideally, if you have even a few years to save, consider investing in an education-specific savings account, which can give you the most bang for your buck, said Stuart Ritter, a senior financial planner at T. Rowe Price.
Typically offered by the states, 529 college savings plans allow holders to save money and withdraw it tax-free, as long as the proceeds are used towards approved college costs -- typically tuition, fees, room, board and other required supplies.
Otherwise, look to other options, such as federal loans, work-study programs and scholarships, said Jeff Vistica, a Carlsbad, Calif.-based financial planner.
And don't take on all the debt yourself. Your child has many more earning years ahead of them to pay off loans than you do so have them carry a larger chunk of the debt burden.
If you're set on dipping into your retirement savings, however, here are some of the pitfalls you should know about:
Thinking about taking a loan from your 401(k)? Get prepared to take a big tax hit. You'll pay back the loan through automatic paycheck deductions using after-tax dollars, and will pay taxes again when you withdraw the funds in retirement.
Plus, if you change jobs and are unable to repay the loan by the deadline, which is usually 60 days, you could be hit with another tax bill and a 10% early withdrawal penalty if you're younger than 59 1/2.
When it comes to taking money from a traditional IRA, a special provision in federal law does away with the 10% early withdrawal penalty if the cash is spent on college expenses. But you'll still have to pay taxes on the money you take out of the account.
Dipping into a Roth IRA can be a better option since you can make withdraws without getting hit with a penalty or taxes. Any investment earnings that you withdraw will still be taxed, however.
Another warning: taxable IRA distributions can count as income for your following year's tax return, which could affect your child's future eligibility for need-based federal aid, such as work study, grants and subsidized loans, said Mark Kantrowitz, a financial aid expert and senior vice president and publisher at Edvisors.com.
"Between the tax hit you may take and the impact on need-based financial aid, you're not netting very much," he said.