Paying the high cost of college in today's climate requires planning and creativity. It is no longer feasible for most families to pay for the full cost of college using just savings, so it's critical to understand how you can go "Beyond the 529" to pay for school. Along these lines, one of the most common questions I get when working with parents is "Is it ever a good idea to tap retirement funds or home equity to pay for school?" Here are some thoughts to consider.
Choosing one of these options should be a last resort.
College should not be looked at in a siloh, apart from your other financial goals like retirement. Good financial planning is about choices and understanding the trade-offs that you are making between your goals. A well thought out college funding plan will always include smart college choices, cash flow and tax planning, and smart lending strategies. So before you make any choices, it's key to understand the long term impact on your overall financial plan.
Considerations for home equity
A home equity line of credit (HELOC) is money that can be borrowed against the value of equity in your home. In order to qualify for a HELOC, consumers must have equity in their home, a good credit score, and a good debt-to-income ratio. For consumers with good credit, the interest rates available with HELOC's may be more favorable than the rates from a Federal Parent PLUS loan or a private student loan. That being said, with Parent PLUS loans and private student loans, your home is not at risk. The Parent PLUS loan offers perks like loan deferment and flexible repayment options that a HELOC does not. Both a HELOC or Parent PLUS loan should only be used to cover a small funding gaps, not the bulk of college costs.
One last consideration for using a HELOC, if you take out a HELOC and the money is in your bank account when you complete the FAFSA, it will be counted as an asset and could affect your family's financial need. If your student may be eligible for need-based financial aid, you do not want the money from the HELOC in your bank account when filling out the FAFSA. There are also important tax considerations to take into account when deciding between a HELOC or student loan that will be the subject of a future post.
Considerations for retirement funds
Withdrawals or distributions from retirement accounts can vary with regards to taxes and penalties, but regardless of which one you choose, using retirement money reduces the amount you have saved and should only be used as a last resort.
Traditional and Roth IRA's
Parents under 59 1/2 years old can make withdrawals from traditional or Roth IRAs without the 10% penalty if used for higher education expenses. The funds must be used for you, your student, your spouse, or your grandchild, and the funds must be used for qualified expenses (i.e. tuition, room & board, etc.) Also, your student must be enrolled more than half time to qualify. Traditional IRA withdrawals will be subject to federal and state taxes, whereas withdrawals from a Roth IRA can be free from taxes, as long as the withdrawal is less than the principal you contributed to the account. Any withdrawals of investment earnings from a Roth IRA that are used for college will be taxed.
Using a 401k
Using a 401k plan to pay for college comes with a 10% penalty if you're under age 59 1/2, and to have this option, you have to meet the criteria for a hardship withdrawal. In addition to the penalty, your distribution will be subject to income taxes. Families of college-bound children are usually at their prime earning years, so your tax rate on these distributions is likely to be high. You could consider taking out a loan against your 401k; however, you will still be subject to the 10% penalty if you're younger than 59 1/2. In addition, a 401k loan comes with the restriction of only being able to have one at a time, and the requirement to pay it back within 5 years. That being said, if you lose your job, you will have to repay the loan within 60 days, which can often put you in a very challenging spot financially.
Impact on need-based aid when using retirement accounts
Money in a retirement plan (IRA, 401k, etc.) is not included in your assets on the FAFSA, and therefore does not count against your need-based aid calculation. However, withdrawals from an IRA or distributions from a 401k will be counted as earned income the following year. This income can be assessed as high as 47%, which means a $10,000 distribution could increase your EFC by as much as $4,700 the following year. If tapping your retirement funds is a necessity, and your student is a need-based candidate, it's key to learn how to avoid this impact.
The Bottom Line
Are you ok putting your retirement at risk to pay for college? If the answer is yes, than one of the options above may be a good one for you. The most successful approach will always include a blend of strategies that includes smart college choices, cash flow options, tax planning, student loans, and only tapping retirement funds when absolutely necessary to close small gaps. No matter what, making the decision to use retirement funds or home equity to pay for college should be done with careful consideration, and should always be evaluated within the context of a comprehensive financial plan.
Mike Bink, AAMS®, CCFS®
Mike works with families to simplify the college funding process and is widely recognized as an expert in college planning. He is passionate about empowering families to become informed consumers of higher education so that they don't pay a penny more for college than they absolutely have to.