Other IRAs & 401(k) Plans

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Saving for college gets easier the earlier you plan. Read more on student loans, 529 plans, education tax credits and other innovative ways to save.

The IRS lets you take out money from a regular IRA or Roth IRA, penalty-free, to pay for qualified higher education expenses. These college expenses can be for you, your spouse, or a dependent for whom you claim an exemption on your tax return.

However, depleting your retirement account has an opportunity cost. You may be meeting a lofty financial goal of paying for a child's college. However, the opportunity cost is that you could be benefiting from compounded growth in a tax-deferred account. As a result, you'll be doing the equivalent of the proverbial "robbing Peter to pay Paul."

In addition to depriving yourself of future growth in a tax-advantaged account, you will also owe income taxes on the withdrawal. Moreover, if you take out more than what you pay in qualified expenses, you'll owe a 10% penalty tax on the amount of excess withdrawals.

Clearly, there are costly trade-offs in taking an early withdrawal from an IRA, no matter what the reason. However, if you insist, you should be diligent to avoid taking excess withdrawals and paying additional taxes. Be sure to include income from the following sources when calculating how much you need to take out:

Broaden your viewpoint when saving for college. Use our calculators to find out how much you'll need to save and plan ahead for future tuition costs.

Any and all sources of extra income or savings. Be sure to add any income earned by the person on whose behalf the qualified expenses are being paid. Include any savings that the beneficiary may have.

Tax-advantaged savings plans. Include as income any money that is in a Section 529 plan that is designated for the same beneficiary.

Loans and gifts. Gifts, grants, scholarships, or any other nonrecurring awards should also be included as income. Include in income any amounts of inheritances from other IRAs.

For more information on taking money from an IRA to pay for educational expenses, see IRS Pub. 970.

Instead of taking money out of your IRA, you may find out that your employer will make you a loan that uses your 401(k) plan assets as collateral. (The IRS doesn't allow early withdrawals from a 401(k) plan to pay for college expenses.)

Similar to taking money out of an IRA, borrowing against your 401(k) plan assets should be a plan of last resort. This is especially true in light of the variety of vehicles introduced in this educator that are available to pay for college.

A major risk of borrowing against your 401(k) plan is that your employer will demand repaymentÂin full and immediatelyÂ if you lose your job. You may find yourself scrambling to take out a consolidation or home equity loan to repay your ex-employer.

However, if you do pursue this source of raising money, be sure to ask your employer to explain the terms and conditions of a 401(k) loan. Terms and conditions may vary widely.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.

2008-07-21 15:28:20