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Why Using Your 401k to Pay for College Might Not Be a Good Idea

Any time a student or their family decides to finance a college education, there are many factors to consider. There is a not a one-size fits all answer to the question, “What is the best way to pay for college?” Every family situation will vary, and the final decision is a very personal one.

So, is it a good idea to pay for college with your 401k? In short—no, probably not. Although you can borrow from your 401k you must consider the consequences of doing that. Any financial planner will caution you against using your 401k as it will impact your own retirement situation.

What are the drawbacks of using your 401k for college?

  • You can borrow money for college, but you cannot borrow for retirement.

  • The money you borrow from your 401k is no longer working for you to earn money for your retirement, which can cause you to fall behind on your own retirement.

  • A 401k loan is a short-term loan, which must be repaid in 5 years. This makes it less suitable for financing a college education.

  • If you lose your job the 401k must be repaid within 60 days of the job loss.

  • If the loan is not repaid, it will be treated as taxable income. If the borrower is under age 59 1/2, the 401k loan will also be subject to a 10% early withdrawal penalty.

  • When you repay the 401k loan, you will be paying with after-tax dollars. You received the tax-break when you put money into the 401k, so you do not get an additional tax break on repayment.

  • If you are unable to contribute to your retirement while you are repaying the loan you will also be losing the benefit of an employer match to your 401k contributions if your employer participates in a match program. Since you will not be contributing to your 401k, neither will your employer.

Using your 401k account as a way to pay for college should be a last resort. Just remember that the best gift to your kids is not college tuition. It is your own, permanent financial independence in retirement. You do not want to be a burden on your kids in the future. College is actually the one expense we can borrow money for without any limit. When you buy a car or a house, banks will only lend you a certain amount, based on your income and assets, but that is not the case when it comes to college there are no limitations. However, there is a limit to how much should be borrowed, but that is a good topic for another post.

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