While you can use your 401(k) to pay for a college education, you really shouldn’t. Your 401(k) was designed to save for retirement. Your child can borrow money for college. You cannot borrow money for your retirement.
Generally, if you withdraw funds from your 401(k) before age 59½, you will owe a 10% early withdrawal penalty, in addition to the income taxes you will owe on the withdrawal. Let’s say you withdraw $3,000. Subtract the 10% penalty of $300, the 28% federal income tax of $840, and then Georgia state tax of 6% of $180. Your $3,000 should cost you $1,320.That is almost reason enough not to withdraw early.
If you need to save for college in a retirement vehicle, consider using a Roth IRA. Withdrawals used to pay qualified college expenses are an exception to the 10% premature distribution penalty on withdrawals made before age 59½. Of course, there are several other savings vehicles designed specifically for education.
If you cannot avoid tapping your 401(k) to pay for college, you may want to consider a plan loan. Most 401(k) plans will let you borrow as much as 50% of your vested account balance, up to $50,000. You will need to check with your plan administrator to determine if loans are allowed and if there are any restrictions. You repay the loan, with interest, from your paycheck. Most plan loans carry a favorable interest rate, usually, prime plus one or two percentage points. You typically have up to five years to repay your loan. However, some plans require that you repay the loan immediately if you leave your job. Additionally, any outstanding loans at employment termination are considered taxable distributions, which means federal and state income tax will be due, as well as the 10% early withdrawal penalty if you are younger than 59½ .
Be warned: your retirement earnings will suffer as a result of removing funds from a tax-deferred investment. William G. Lako, Jr., CFP®, is a principal at Henssler Financial, and a co-host on Atlanta's longest running, most respected financial talk radio show "Money Talks" airing Sundays at 10 a.m. on Talk 920 AM, WGKA.