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The Perils of Using a Retirement Account for College Costs

Emily Brandon

Sometimes parents raid their retirement accounts to help pay for their child's education. Some 7 percent of families withdrew money or initiated a loan from a retirement account to pay for college in 2013, taking an average of $3,256 from their nest egg, according to a recent Sallie Mae and Ipsos Public Affairs survey of 802 parents of undergraduate students and 800 students. Here's how these early distributions will ultimately impact the parent's retirement finances:

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401(k) loans. 401(k) loans are generally the least damaging way to tap your retirement accounts early, because, if all goes well, you will pay yourself back with interest. Account owners can generally borrow as much as 50 percent of their vested 401(k) balance up to $50,000. 401(k) loans for education expenses must be repaid within 5 years, and you must make payments at least quarterly over the life of the loan. However, if you leave the job or are laid off, the entire balance could become due sooner. Loans that are not repaid will be considered withdrawals and income tax and a 10 percent early withdrawal penalty may be applied. 401(k) loans often have a variety of fees including administration, origination and maintenance fees.

Only 1 percent of families took out a retirement account loan in 2013, averaging $3,952, Sallie Mae found. This is similar to the 2 percent of families who borrowed $4,357 in 2012. Parents of students at 4-year private schools generally borrowed more money from their retirement accounts than parents of children attending public colleges.

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Early withdrawals. In 2013, 5 percent of families took a retirement savings withdrawal averaging $2,710. The same proportion of families withdrew money in 2012, but they took out much more, averaging $6,542. Parents of freshmen (6 percent) were slightly more likely to withdraw from their retirement accounts than parents of upperclassmen (3 to 4 percent).

401(k) hardship distributions. 401(k) hardship withdrawals can be taken to pay for higher education costs if your employer allows it. However, a 401(k) distribution permanently reduces your retirement account balance, and can also trigger a variety of taxes and penalties. Hardship distributions, unless they are from Roth accounts, are generally subject to income tax. If you are under age 59 1/2, an early withdrawal penalty may also be applied to the distribution. Retirement account withdrawals are counted as income in federal financial aid calculations and may reduce your child's eligibility in future years. And employees are often prohibited from making new contributions to the 401(k) plan for 6 months following a hardship distribution, which makes it even more difficult to replace your retirement account balance.

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Early IRA withdrawals. IRA distributions used to pay for higher education expenses are exempt from the 10 percent early withdrawal penalty. Qualifying higher education expenses include tuition, fees, books and supplies required by the educational institution for you, your spouse or the children or grandchildren of you or your spouse. Room and board also qualify for the exception if the individual attending college is at least a half-time student. However, regular income tax is still due on traditional IRA withdrawals, and distributions could also reduce your child's eligibility for financial aid.

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