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Retirement funds may help your pay for college expenses. You can withdraw funds from your IRA without penalty to pay qualified higher education expenses. You can also borrow from your 401(k).

Penalty-free Withdrawals from Individual Retirement Plans

Normally, if you withdraw money from a traditional or Roth IRA before you reach age 59-1/2, you would pay a 10% early distribution penalty on the distribution, in addition to any regular income tax due. There is, however, an exception for distributions used to pay qualified higher education expenses. The portion of the distribution used for qualified higher education expenses is exempt from the 10% early distribution penalty. You will still pay income tax on the portion of the distribution that would otherwise have been subject to income tax. All this exception does is avoid the 10% additional tax on early IRA distributions. The qualified higher education expenses must be for you, your spouse, your children or your grandchildren. Qualified higher education expenses include tuition, fees, books, supplies and equipment, as well as room and board if the student is enrolled at least half time in a degree program.

The advantages of the elimination of the early withdrawal penalty are as follows:

• This effectively turns a traditional IRA into a tax-deferred college savings vehicle.
• If you limit your withdrawals from a Roth IRA to just the contributions, the distribution is tax and penalty free when used for qualified higher education expenses.
• Funds in a traditional IRA are sheltered from the financial aid need analysis, and so have no impact on financial aid eligibility.
• Asset control remains with the parent.
• There is no income phaseout.

The disadvantages of using penalty-free withdrawals from individual retirement plans are as follows:

• Although the amounts in a traditional IRA are sheltered from need-based financial aid, the amounts withdrawn may count as income and affect eligibility for need-based financial aid during the next year. (If the distribution is tax-free, it counts as untaxed income and still impacts the need analysis process.)
• The current year contributions to a traditional IRA are counted as untaxed income, even though the amounts in the IRA are ignored as an asset.
• The distribution must occur during the same year in which the qualified expenses are paid, so you cannot withdraw the funds a year before or a year afterward.
• You are using up your retirement savings. Once the money has been withdrawn from the IRA, you can't put it back. The only way to increase your IRA balance is through the normal contributions, which are subject to the annual limits.
• Qualified education expenses can be used to justify only one education tax benefit. You can't double-dip. If you use them to justify a penalty-free withdrawal from your individual retirement account, you can't use the same expenses to justify a Hope Scholarship or Lifetime Learning tax credit.

Some parents use a Roth IRA as a combined college and retirement savings vehicle. When they need to pay for college expenses, they limit their withdrawals to the contributions in order to avoid paying any income taxes on the distribution. The earnings remain in the Roth IRA to pay for retirement. The main problem with this approach is the distributions count as untaxed income on next year's FAFSA, reducing eligibility for need-based financial aid.

In most cases you will be better off using a section 529 plan for your college savings. Penalty-free withdrawals from retirement funds are mainly useful when you didn't plan ahead and need to tap your retirement savings to pay for college expenses. A Roth IRA might also be a useful college savings vehicle for grandparents, who start saving at least five years before turning age 59-1/2, and won't otherwise need the funds for their own retirement. But generally speaking, withdrawing money from your retirement plan should be considered only as a last resort.

Borrowing from Your Retirement Plan

You may be able to borrow money from your retirement plan to pay for college expenses for yourself, your spouse, or your children. For example, you can borrow up to half your vested balance in your company 401(k) plan or $50,000, whichever is less. Typically such loans charge a percentage point or two above the prime lending rate.

Similar rules may apply to 403(b) plans (for employees of a nonprofit organization) and 457 plans (for public employees), but not IRAs. You cannot borrow from an IRA. Also, although federal law permits borrowing from a 457 plan, it is common for 457 plans to be more restrictive and not permit borrowing from the plan.

The advantages of borrowing from your retirement plan are as follows:

• The interest you pay goes back into your retirement account, so you're paying yourself.
• The loan will have no impact on eligibility for need-based financial aid.
• The savings you borrow are still tax-deferred.
• Funds from a retirement plan loan are not subject to income tax or the 10% early withdrawal penalty.

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The disadvantages of borrowing from your retirement plan are as follows:

• The loan must be repaid in five years.
• If you quit, are fired, or are laid off, your loan may be due immediately.
• If you can't repay the loan, the remaining balance owed will be considered a taxable distribution and there will be a 10% early withdrawal penalty if you aren't 55 or older. There may also be state tax penalties.
• The interest you pay is not deductible. The money you use to repay the loan is coming from after-tax dollars, and so you're losing the benefit of the retirement plan as a tax shelter.
• The money you borrow is no longer invested in your retirement fund. You are effectively substituting the interest you pay for the money the retirement funds were earning.
• Although you're paying yourself interest, those interest payments are coming from your other savings or income. So, in effect, you are losing the money your retirement funds would otherwise have been earning, plus all the compounding.
• If you sell shares within your retirement fund to provide funds for the loan, you'll be taking a loss inside the plan, where it offers you no tax benefit.

There are several low-cost Federal education loan programs available, such as the Stafford loan for students and the PLUS loan for parents. You are better off borrowing from one of these programs than from your retirement plan, since the interest on the education loans will likely be less than the lost earnings on your retirement plan. In addition to low interest rates, the Federal education loans also have longer and more flexible repayment terms, partial tax deductibility, deferments and forbearances. Another alternative is to get a home-equity loan if you own your home. Not only do home equity loans offer low interest rates, but the interest may be deductible on your income taxes.

Hardship Withdrawals from Your Retirement Plan

You can make a hardship withdrawal from your 401(k) to pay for college tuition and related expenses (including room and board) for yourself, your spouse, your dependents, and children (including children who are no longer dependents). The withdrawal must be to pay for the educational expenses and you must have no other way to pay for the expenses. You must have also have already obtained any distribution or loans available to you under the 401(k) plan. However, the withdrawals will be subject to income tax. If you are not at least 59-1/2 years old, there will also be a 10% early withdrawal penalty. You will also be precluded from contributing to the 401(k) plan for the six months following the withdrawal.