Higher education is expensive and it is forcing more and more families to access mom and dad’s retirement funds to settle with the bursar.
According to a Sallie Mae and Ipsos survey published today, 7 percent of parents withdrew money from retirement accounts to pay for college expenses in 2014. A similar survey in 2013 showed that only 5 percent of families used retirement funds for this purpose. What is even more surprising is the average amount of money parents withdrew: $8,870 in 2014 compared to just $2,710 in 2013. In addition, 1 percent of families took out loans against their retirement funds, with an average loan of $5,062 in 2014 compared to $3,952 in 2013.
The Cost of Withdraw
Using retirement money for higher education is one way to pay the increasing costs of tuition, but is it a good idea? Under current tax laws, the answer to that question is “No.” The reason is because, since retirement accounts carry special provisions against withdraw, the parent who taps a retirement account is going to be hit with penalties, taxes, or both.
Different Situations, Different Rules
Of course, the rules of the retirement money withdraw game are not the same for everyone (are tax laws ever simple?). If you are under the age of 59.5 and take money from your 401k or IRA, you will have to report the withdraw as taxable income. This can make a withdraw of funds for educational purposes very unattractive, particularly for those in higher tax brackets. But there’s more: Because the withdraw counts as income, it also increases the parents’ reported IRS earnings. And that means the kids will qualify for less financial aid than before.
The one bright spot is that, under current tax laws, the customary 10 percent penalty for early retirement fund withdraw is waived if the money is used for higher education. And the cool fact is that this rule applies for money used for tuition by not just the children, but also the parents themselves and even the grandchildren.
Is there a way to pay for your kid’s tuition and avoid income tax? Yes, there are some options available. If you have a Roth IRA, your tax is limited- you pay tax only on the withdraws that came from investment gains. In other words, if I have invested $10,000 in my Roth IRA and my account has grown to $15,000 in value, I can withdraw the original $10,000 tax free if used for educational purposes. I only have to pay tax on any withdraw above and beyond the $10,000 I invested.
Another way to avoid taxes on any type of retirement account is to take out a loan instead of making a withdraw. Of course, this means you will have to pay it back. But with a loan, there is no penalty, taxes, or other considerations. Yes, you have to pay the money back with interest, but you are paying yourself the interest. As long as you can be disciplined and pay the funds back as promised, in the end you may end up with even more money than before.
College Tuition and the Future
No one knows what will happen in the future. The rules described above are those as they now stand and are based on current tax laws. These laws can change at any time and for any reason. When your child reaches college age, they may be completely different from what is described.
Here at Money Saving Parent, we predict that the U.S. government will likely ease the penalties and taxes relating to retirement fund withdraw over time. We believe this will happen because the government will decide that allowing more flexibility of withdraw is still better than the government having to foot the bill. As budget cuts become the norm and student aid is on the chopping block, there will need to be some way to help parents make up the difference and softening the rules for retirement withdraw- as long as the money goes toward educational expenses- is one obvious solution.
Without knowing what to expect and with tax laws so uncertain, the best approach to the problem is to establish a 529 or similar educational expense fund for your children right now. Save as much as you can using these educational accounts and much of your future worries will disappear. True, you may or may not save enough and may have to access retirement accounts regardless, but with educational savings already established, the bulk of higher education costs will be covered and the changes in tax laws won’t matter so much. So, if you haven’t already done so, start saving now. Your future financial life and that of your children will be much brighter and more predictable.
Copyright 2014, Bryan Carey