There are several options for using retirement plans to pay for college, including early distributions from an IRA, using a tax-free return of contributions from a Roth IRA, loans from a 401(k) or 403(b) plan and hardship distributions from a 401(k) or 403(b) plan.
Early distributions from an Individual Retirement Account (IRA) are subject to a 10% tax penalty if the account owner has not yet reached age 59-1/2.
The 10% tax penalty is waived for early distributions to pay for qualified higher education expenses at a Title IV college or university that is eligible for federal student aid. The distribution will still be taxed as ordinary income.
The tax penalty waiver applies to all IRAs, including traditional IRAs and Roth IRAs, as well as SEP and SIMPLE plans. 401(k) and 403(b) plans are not eligible.
Qualified higher education expenses include the same qualified higher education expenses as for 529 college savings plans. The qualified higher education expenses include tuition, fees, books, supplies, equipment, and special needs expenses, as well as and room and board (if enrolled at least half-time). They do not include K-12 tuition or student loan repayment.
The early distributions are limited to paying for the qualified higher education expenses of the taxpayer, spouse, children and grandchildren, including adopted children and foster children.
Contributions to a Roth IRA are made with after-tax dollars and qualified distributions are entirely tax-free.
A return of contributions from a Roth IRA is tax-free and penalty-free even if the account owner has not yet reached age 59-1/2. Thus, a tax-free return of contributions from a Roth IRA can be used to pay for college, repay student loans or any other purpose.
However, a tax-free return of contributions from a Roth IRA is reported as untaxed income on the Free Application for Federal Student Aid (FAFSA). As much as half of the distribution will reduce eligibility for need-based financial aid.
However, given that the FAFSA uses prior-prior year income, Roth IRA distributions that occur on or after January 1 of the student’s sophomore year in college will not be reported on the FAFSA, assuming that the student graduates from college in four years. If the student will graduate in five years, then distributions should be made on or after January 1 of the junior year in college. The safest solution is to wait until the student graduates from college and to use a tax-free return of contributions from the Roth IRA to pay down student loan debt.
Employees can borrow money from their 401(k) and 403(b) retirement plans, if the retirement plan offers retirement plan loans. IRAs are not eligible.
Retirement plan loans may be made for any purpose, including higher education expenses.
The aggregate loan limit is $50,000 or half the vested balance in the retirement plans, whichever is less. If the vest balance is less than $10,000, the aggregate limit is $10,000.
The repayment term is 5 years or when the employee loses their job, whichever comes first.
If the employee does not repay the plan loan within the repayment term, the remaining loan balance will be treated as a distribution.
Most employer plans suspend contributions to the retirement plan until the retirement plan loan is repaid in full. This can cause the employee to miss the employer match on contributions to the retirement plan.
Employees should consider borrowing from federal student and parent loans before turning to a retirement plan loan. Although the interest paid on a retirement plan loan is added to the employee’s retirement savings, this merely replaces the income the retirement plan would have earned if the money had remained invested in the retirement plan.
Hardship distributions made be made from a 401(k) or 403(b) retirement plan to pay for college tuition, fees, room and board during the next 12 months. 457(b) retirement plans are not eligible.
Hardship distributions are subject to income tax. If the account owner has not yet reached age 59-1/2, the hardship distribution will also be subject to a 10% tax penalty.
The CARES Act waived the 10% tax penalty for hardship distributions made in 2020 and increased the limit to $100,000 in certain circumstances related to the pandemic. The distribution is still taxable, but the taxes can be paid over three years. Under the CARES Act provision, one can put the hardship distribution back into the retirement account within three years, making it similar to a retirement plan loan. The 20% tax withholding for a hardship distribution is also waived.
Former employees can rollover a 401(k) or 403(b) retirement plan into an IRA and then take an early distribution to pay for college costs.
A hardship distribution from a 401(k) or 403(b) is limited to tuition, fees, room and board and may be subject to the 10% tax penalty if the taxpayer hasn’t yet reached age 59-1/2.
An early distribution from an IRA has a broader set of qualified expenses and avoids the 10% tax penalty.
So, rolling over a 401(k) or 403(b) retirement plan into an IRA is a better option for using a retirement plan to pay for college costs.
Converting a traditional IRA into a Roth IRA will result in taxable income that is included in adjusted gross income (AGI). The increased income will affect the student’s eligibility for need-based financial aid.
However, the student or parents can appeal to the college financial aid office to exclude the exclusion from income on the FAFSA.
Use our Financial Aid Calculator to estimate the expected family contribution (EFC) and your financial need.
The U.S. Department of Education issued Dear Colleague Letter GEN-99-10 in February 1999 to encourage colleges to use professional judgment to reduce income and taxes corresponding to a Roth IRA conversion. The letter notes that a Roth IRA conversion does not provide the family with additional income to pay for college.
A coronavirus-related hardship distribution from a 401(k) plan under the CARES Act does not reduce qualified higher education expenses for qualified distributions from a 529 plan.
Qualified higher education expenses (QHEE) are reduced by tax-free educational assistance, such as the tax-free portion of a grant, scholarship or fellowship, veterans’ educational assistance, and employer-paid educational assistance.
There are also coordination restrictions with the American Opportunity Tax Credit (AOTC) and Lifetime Learning Tax Credit (LLTC) that effectively reduce the qualified higher education expenses by the amount of qualified higher education expenses that were used to justify the AOTC or LLTC.
A hardship distribution from a 401(k) plan remains taxable and therefore is not considered to be tax-free educational assistance. The CARES Act benefit waives the 10% tax penalty but the distribution is still taxable.