If you are over 59½ or leave your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay for anything you like. If you are younger, you can still withdraw funds from your 401(k) to pay off college loans, but the IRS charges a 10% penalty tax on the amount of your withdrawal, in addition to any income tax that may be due. However, there are a few ways you may be able to use your retirement savings to pay for your education without incurring this penalty.
If you already attended college and used student loans to pay your tuition, a hardship withdrawal cannot be used to repay your loans. However, if you are planning on attending school in the next year and cannot otherwise afford to pay your tuition, you may be able to withdraw money from your 401(k) to pay your tuition, room, and board, and other related expenses using this tool.
Also, you may be able to take a hardship withdrawal to pay the tuition and education expenses of a child, spouse, or dependent who is planning on attending school within 12 months.
To qualify for a hardship withdrawal to fund your education, you must meet certain criteria. Firstly, you must be able to prove your need is immediate and heavy. A student loan is not an immediate expense because it already provides for repayment over time. However, tuition for the upcoming school year does qualify as immediate.
For your need to be considered heavy, the expense must be important and large enough that it could not easily be met by working a few more hours or cutting out your weekly movie night. Besides college tuition, other expenses that are considered immediate are the down payment on a primary residence and qualifying medical expenses that exceed 10% of your adjusted gross income (AGI).
When assessing your need, your plan administrator evaluates any other assets you have at your disposal, such as checking or savings accounts, investments, and property holdings. If liquidating one of your other assets enables you to pay your tuition without taking a distribution from your 401(k), then your hardship withdrawal is declined.
Be Your Own Lender
Instead of taking out traditional student loans, you may be able to fund your college education by taking a loan from your 401(k). Rather than repaying a bank, you make payments of principal and interest back to your own retirement account.
Loans from your traditional or Roth 401(k) retirement account are limited to 50% of your vested account balance, up to $50,000. You may take out multiple loans at different times, but your maximum outstanding balance may not exceed $50,000.
Also, qualified loans taken from your 401(k) are not subject to income tax, provided that the loan is paid off within a predetermined period. Generally, the borrowed funds must be repaid within five years in regular, substantially equal payments, at least quarterly. However, if you serve as a reservist in the U.S. military and are called to service, the term of your loan is extended to include the duration of your service.
The Bottom Line
Taking a straight distribution from your 401(k) to repay your student loans is not the most efficient use of your retirement savings. However, if you have not yet attended university, you may be able to take advantage of your savings with a little careful planning.
If you meet the requirements for a hardship withdrawal, you may withdraw retirement funds up to the amount of your tuition and expenses without incurring additional taxation. Even if you do not meet these stringent criteria, you may still be eligible to take a tax-free loan of up to $50,000, enabling you to gain a higher education without sacrificing your long-term nest egg.