09/17/2020

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Paying for College: Should Parents Take Out Loans or Tap Retirement Savings?



With higher education expenses galloping far ahead of inflation, parents at all income levels are finding it difficult to help out with their kids’ college education. If you’re one of many parents whose savings is coming up short, even with a 529 Savings Plan, a Coverdell, or other education-specific plan in place, you may be considering other options to cover the expense gap, including taking out a loan or dipping into retirement accounts.

Before going either route, be sure to fully explore the options available to your family, including potential grants, financial aid, work study programs and employer-provided education assistance programs. And if it’s too late to apply or your child won’t qualify for financial aid, your family may still qualify for one of the tax credits or deductions currently available. While these education-related tax credits won’t necessarily help every family due to limitations and income level phase-outs, they are worth exploring if you’re new to the education funding process.

If you want to explore using retirement savings or private loans to help close the funding gap, here is an overview of the available options in those areas.

401(k) Loan
Most employers will allow you to borrow money from your 401(k). If your employer has a policy in place that allows this, and you have enough retirement savings to support it, it may be worth considering. Here are some pros and cons:

Pros:

*The interest rate on a 401(k) loan may be lower than standard bank rates.
*These can be relatively easy to obtain. Often they don’t require a credit check and can be requested online.

Cons:

*Federal laws limit borrowing to 50% of the vested account balance, up to a maximum of $50,000, and require loans to be repaid within five years.
*When you remove money from your tax-deferred account, even temporarily, you’re missing out on valuable compounding and capital appreciation on those funds. You need to consider how these distributions will impact your retirement goals.
*401(k) loans are repaid with after-tax dollars, so not only do you miss out on investment returns, compounding and any employer match, you’ll actually pay taxes on the loan amount twice: when you earn the money and when you draw down the funds during retirement.
*Keep in mind that if you have to leave your job for health reasons, or you get fired or laid off during the loan term, you will need to repay the loan within 30 days to avoid the mandatory 10% IRS penalty and taxes on early withdrawals if you’re younger than 59 ½.

The biggest consideration with a 401(k) loan is that you have to be honest with yourself about whether your retirement savings can really afford to take that hit. Given the retirement crisis happening in the U.S. today, there are many nest eggs that can’t.

Retirement Account Withdrawal
If you choose to take a distribution from an individual retirement account (IRA) rather than a loan against your 401(k), you need to understand whether the distribution will be subject to income tax and /or is subject to a penalty. Normally, there is a penalty for withdrawals taken from retirement accounts prior to age 59 ½, however there can be an exception if the withdrawal goes towards higher education expenses. The amount distributed will generally be treated as taxable income.

It may be worth exploring this option if you’re over 59 ½ and have a qualified retirement account that is more than 5 years old, but you need to be sure that tapping this source won’t significantly impact your retirement goals. To figure out if you are on track for retirement, consult our retirement calculator.

Parent Loans
The two main options for parents seeking an education loan are federal Parent PLUS loans and private parent loans.

Parent PLUS loans

Pros:

*You can borrow as much as your child needs up to the cost of their education, minus any additional aid they’re receiving.
*There are flexible repayment options like graduated and extended plans.
*There are options to put loans on hold due to hardship through deferment and forbearance.
*The financial history requirements are less strict than with private lenders.

Cons:

*Every borrower gets the same interest rate, regardless of creditworthiness – which means you could get a lower rate through a private lender. As of July 2015, the interest rate is 7.21%.
*Large origination fee (4.292%).
*Limited terms available (10 or 25 years).

Private loans

Pros:

*For borrowers with strong financial history, it’s possible to get a lower interest rate than a Parent PLUS loan.
*Private loans are typically more flexible in terms of offering shorter/longer terms and variable/fixed rate loans.
*May have enhanced customer service, including weekend hours.
*Some have no origination or other fees.

Cons:

*May have origination or other fees.
*Private lenders don’t typically offer deferment or flexible repayment plans, but may offer forbearance.
*Traditional banks may cap the amount you can borrow.

As you can see, not all loans are alike, so you’ll want to take the time upfront to choose the right option for you – after all, you may be stuck with this loan for a while.

 

Helping a child pay for college is a noble goal – one that most of us aspire to in some capacity. After all, workers with a college degree will typically earn 70% more than those with a high school diploma. Just be sure to make an informed decision about financing. Whether you’re faced with eroding your retirement savings or paying interest on a loan, the choice you make today can make a big impact in your – and your child’s – financial tomorrow.

 

This article is intended to provide useful information about personal finance, but it is not intended to provide legal, investment or tax advice.


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