Paying the high cost of college requires a multipronged attack. For most families, a 529 plan on its own is not enough to cover the out of pocket expense of college. They simply can’t save enough in a 529 to cover it all. The number of years to save for college is short, and every dollar is stretched thin for young families. Many young parents still have student loans of their own. When faced with the high cost of college, parents may be forced to consider using their retirement funds or home equity to help pay the costs.
Is it ever a good idea to tap retirement and home equity?
Choosing these options should be done as a last resort. Normal families across the country are figuring out how to pay for college without going broke or taking on insane amounts of debt. A well thought out college funding plan will always include a smart college choice, cash flow, tax planning, and smart lending strategies.
College should not be looked at in a vacuum. Good financial planning is about choices and understanding the trade-offs that you are making if you raid your retirement or home equity. Preserving your retirement assets and retiring mortgage free are high priorities. You will either need to work longer, or retire on less. Be sure you understand the long term impact on your overall financial plan.
Let’s look at your home equity first
A home equity line of credit (HELOC) is money that can be borrowed against the value of your home minus any other outstanding mortgage amount. In order to qualify, consumers must have enough equity in the home, a high credit score, and a good debt-to-income ratio. For HELOCs, typically lenders want the loan to value (LTV) to be 80% or less.
A HELOC is a mortgage with a revolving balance, like a credit card, with an interest rate that typically varies with the prime rate. You only access the funds that you need when you need them. For consumers with good credit the interest rate available via a home equity line of credit may be more favorable than the rate from a Federal Parent PLUS loan or a private student loan.
But here’s the deal, do you want to put your home at risk to pay for college? The Parent PLUS loan may have a higher interest rate, but it comes with some perks like loan deferment and flexible repayment options that a home equity line of credit does not. A home equity line of credit should only be used for small funding gaps. We give the same guidance for the Parent PLUS loan–only use it to cover a small gap.
Also, be aware that if you take out a home equity loan or line of credit and the money is in your bank account when you complete the FAFSA, it will be counted against you as an assessable asset in the financial aid calculation. Students who may be eligible for need-based financial aid do not want the money from their home to be sitting in their parents’ bank account when they fill out the FAFSA.
Tax considerations when using loans
An important federal tax consideration is the deductibility of interest on loans. With the changes made by the Tax Cuts and Jobs Act of 2017, loan interest on a home equity line of credit is only deductible if used to buy, build or substantially improve the taxpayer’s home that secures the loan. Using a HELOC to pay for college does not qualify.
If a student loan is taken out instead, some tax filers depending on their Adjusted Gross Income (AGI) may claim the interest up to the lesser of the actual amount of interest paid or $2,500. This deduction can be claimed without itemizing. It is on the first page of the 1040 tax form and reduces the AGI.
What about those retirement funds?
Common retirement saving vehicles include 401k or 403b plans, traditional IRAs, and Roth IRAs. How these withdrawals or distributions are handled in terms of penalties and taxes can vary slightly. Of course, using retirement money to pay for college reduces the amount you have saved so should only be used as a last resort.
Traditional and Roth IRA
Parents under 59 1/2 years old can make withdrawals from traditional IRAs or Roth IRAs without the 10% penalty when used for higher education expenses. The funds must be used for yourself, your spouse, your child, or your grandchild. The funds must be used for qualified expenses like tuition, room, board, and necessary fees. The student must be enrolled more than half-time to qualify.
Traditional IRA withdrawals will be subject to federal and state taxes. Withdrawals from a Roth IRA used for higher education (if under 59 1/2) can be free from tax liability if you limit the withdrawal to an amount up to the amount you contributed. Withdrawals of investment earnings will be taxed. (Note that not all people qualify for saving in a Roth IRA. For the 2019 tax year single filers must have a modified adjusted gross income (MAGI) of less than $139,000, and married filing jointly couples must have an MAGI of less than $203,000.)
Using a 401k plan to pay for college is subject to serious penalties. In order to qualify for a 401k distribution to pay for higher education expenses, you must qualify for a hardship withdrawal and may have to show that you have exhausted all other college financing options. Your distribution will be subject to income taxes. Families of college-bound children are often at their peak earning years so their tax rate on these distributions will be high.
In addition, the withdrawals will also be subject to a 10% penalty if you are under 59 1/2. There is no exemption like there is for IRAs.
If you wish to take out a loan on your 401k, do so with caution as you will be hit with the 10% penalty if before 59 1/2. Remember, you can only have one loan at a time, and they need to be paid back within five years. If you lose your job, the loan needs to be paid in 60 days. You are borrowing from yourself instead of a third party and will pay the interest to yourself.
Impact on need-based aid
Money in a retirement plan is not included in your assets on the FAFSA. In other words, retirement money does not count against your need-based aid calculation. However, withdrawals from an IRA or distributions from a 401k will be counted as earned income the following year. This income can be assessed as high as 47%! So, taking a $10,000 distribution from your traditional IRA could increase your EFC (expected family contribution) by as much as $4,700 the following year. If tapping your retirement funds is a necessity and you are a need-based candidate, choosing to do so in the final/senior year typically will not affect your financial aid.
When thinking about saving, keep this in mind.
IRAs and a 529 plans could both be considered tax-deferred savings options for college. However, because contributions to an IRA are limited every year ($6,000 per year/$7,000 age 50 years or older), a 529 plan is the preferred savings vehicle if using those funds to pay for college is your intent.
A blended saving strategy that balances tax advantages and flexibility upon distribution is important to consider. Frequently this is a combination of Roth IRA, 529, and tax efficient mutual funds.
The final analysis
The key question to consider; do you want to risk your retirement? Yes, paying for college is a huge bill, but you have many options available to help you. Can you get a loan to pay for college? Yes. Can you get a loan to pay for retirement? Not really. Making the decision to use retirement funds to pay for college should be done with careful consideration.
In general, we always stress a blended approach to incorporate smart college choices, cash flow options, tax planning, student loans, work-study, and only tap retirement and home equity to fund a small gap. Understanding the impact on your retirement and taking a holistic approach is always the wisest course.