Using a 401(k) Loan to Pay for Education: Everything You Need to Know
Going to college is a major expense. What’s more, the costs of higher education continue to increase year over year, making it virtually impossible for some people to afford. Often, people don’t know how they’re going to afford to pay for tuition.
Fortunately, there are a number of options individuals can choose from when they’re coming up with the funding they need to obtain a degree. From scholarship funding to federal grants and personal loans, there are multiple ways to access money for school. Using a 401(k) loan is yet another example of how you can pay for college.
A 401(k) plan is a way for you to earn retirement funds through tax-deferred investments. Most often, a 401(k) is established through your employer.
Learn more about how you can use your 401(k) to borrow or remove money to pay for schooling, as well as some more alternative methods to use if you don’t yet have a 401(k).
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Can You Use Your 401(k) to Pay for College?
Yes, you can use your 401(k) to pay for college. While it’s possible to borrow money from your retirement fund, it’s not often recommended that you do so.
There are two ways you can use your 401(k) to pay for college: a loan and a withdrawal. Below, we’ll explain how each works, but ultimately, the amount of money you borrow or take out from your 401(k) will be determined by the type of retirement plan you have. Regardless of whether you’re using your 401(k) to take out a loan or a withdrawal, a 10% penalty tax will be charged if you are under 59½ years of age. Additionally, any income tax that is owed on your investment may be charged as a penalty.
Essentially, a 401(k) loan isn’t truly a loan, as you’re “borrowing” the funds from your own retirement account and then replenishing them with interest. In other words, you’re the borrower and the lender.
Because a 401(k) is supplied by your employer, they, along with the IRS, determine how much you can borrow against your 401(k). If your employer allows you to borrow, the IRS states that you may borrow up to 50% of your account balance, for a maximum of $50,000.
The IRS also sets the repayment terms. You must pay back the loan within five years unless the 401(k) funds are used to pay for a home. When you repay your 401(k) loan, you must make quarterly minimum payments over the life of the loan, or in this case, the amount of time you’re in school.
You can also withdraw funds directly from your 401(k) account to pay for your education. The IRS allows withdrawals to be made from 401(k)s in certain instances, including paying for school.
In the event that you are taking money out of your 401(k) for a hardship withdrawal, you must demonstrate that you have an immediate financial need. IRS regulations state that an employee is automatically considered to have an immediate financial need if the distribution is for tuition or related educational fees. A hardship withdrawal can cover the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary.
The amount you’re able to take out is limited to the amount you need — in this case, the cost of tuition. The money you take out is taxed, but since it’s a withdrawal, you don’t have to pay it back into your 401(k) account. Most often, early withdrawals from a retirement account are charged a 10% penalty tax, but the IRS makes an exception when the money is used for tuition and other higher education costs.
Pros of Using Your 401(k) to Pay for College
There are many pros of using your 401(k) to pay for college:
- You’re paying interest to yourself instead of a third party.
- The loan is not reported on your credit history, even if you default on it.
- You don’t need a credit history to borrow from your 401(k).
- It’s better to borrow from yourself rather than the federal government — interest rates can be high on student loans. The 401(k) interest rate generally sits a point or two above the prime rate.
- 401(k) loans don’t secure your home as collateral — if you default on the loan, your home is safe.
- Borrowing from 401(k) won’t lessen your chances of receiving other forms of financial aid.
Cons of Using Your 401(k) to Pay for College
As with any financial matter, there are cons to using your 401(k) plan to pay for college, including:
- It’s a short-term loan that needs to be repaid in five years.
- If you lose the job that you’re receiving the 401(k) from, the loan must be paid back within 60 days of your job loss.
- You’re taking away from your retirement funds and unable to contribute to them until repayments are made.
- Unpaid loans are treated as taxable income and potentially subject to the 10% early withdrawal fee.
- There is double taxation on the loan payments, causing you to lose some of the tax benefits a 401(k) otherwise provides.
- Unlike traditional forms of student loans, the interest on a 401(k) loan is not tax-deductible.
Alternative Ways to Pay for College
Whether you don’t have a 401(k) yet or you’re not sure borrowing or withdrawing from your retirement fund is a good idea, there are still other ways you can pay for college. Alternative methods to pay for your college tuition include:
- Federal student loans.
- Private student loans.
- Tax credits.
- Attending community college.
Borrowing against your 401(k) to pay for college can create short- and long-term financial hardships down the road. Before you do so, be sure to consider the alternative methods of paying for college and weigh the pros and cons that a 401(k) disbursement will have when it comes to your individual situation.
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