If you are over age 59½, 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, you can borrow from your 401(k) instead of taking out a student loan, and there are a few ways you may be able to use retirement savings to pay for college expenses.
Borrow From Your 401(k)
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.
- If you are younger than 59½, you can’t withdraw funds from a 401(k) to pay off a student loan without being subject to a penalty.
- It’s possible to borrow from a 401(k) instead of taking out a student loan.
- A less appealing option is to take a hardship withdrawal, you can use it to pay for tuition and education expenses, but it may be subject to penalty and taxes.
- It’s also possible to pay for education expenses with IRA funds without paying an early withdrawal penalty if you follow specific rules.
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. Keep in mind that plan sponsors aren’t obligated to offer 401(k) loans and can limit the amount and repayment terms to less than what is allowed by the IRS.
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.
There are also drawbacks to borrowing from your 401(k) that must be considered. One downside is that funds that are withdrawn from your account as a loan lose out on potential tax-deferred growth on earnings.
Take a Hardship Withdrawal
A less appealing option to pay for higher education expenses with funds from your 401(k) is a hardship withdrawal. 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 plan 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.
Unlike a loan, funds from a hardship withdrawal cannot be paid back to your 401(k) account.
You may also 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. Either way, if you are younger than 59½, you will still pay a 10% penalty on the amount withdrawn and also be subject to income tax.
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 include permanent disability and qualifying medical expenses that exceed 7.5% of your adjusted gross income (AGI). In these instances, there is no 10% penalty levied.
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. Also, if your plan allows you to obtain a 401(k) loan to satisfy the need, your withdrawal might not qualify as an immediate and financial need.
Tap an IRA Instead
If you have an IRA, you can use funds from it to pay education expenses for you or your spouse, children, or grandchildren without paying the 10% penalty if you follow specific rules.
While IRA withdrawals cannot be used to pay student loans, they can be used for qualified education expenses at an eligible institution. Qualified expenses include tuition, books, and supplies, among others.
There is an alternative to using funds from a 401(k) to pay down any amount owing to a qualified student loan, thanks to the Setting Every Community Up for Retirement Enhancement Act (SECURE). Signed in December 2019, the new law expands the rules for 529 plans, allowing account holders to withdraw a lifetime maximum of $10,000 to pay student debt of the plan's beneficiary or their sibling. The withdrawal is tax- and penalty-free at the federal level. But it may be considered a nonqualified distribution in your state, so it's worth verifying how it is treated at the state level.
The Bottom Line
Taking a straight distribution to pay your student loans or a hardship withdrawal to pay for higher education expenses is not the most efficient use of your retirement savings, particularly if you are under age 59½.
Borrowing from your 401(k), if your employer allows, can be an alternative to taking out a student loan, though it's important to weigh the pros and cons before doing so. If you have an IRA, you can make a withdrawal penalty-free for qualified education expenses at an eligible institution.