You can borrow for college, but not for your retirement
When it comes to saving for college, readers have many questions, especially about tax-advantaged “529” college-savings accounts, which allow money to grow tax-free in mutual funds if used for qualified higher-education expenses.
‘Should I dip into my retirement account to pay for college?’
People do it, but most financial professionals advise against it. At the very least, experts say, you should limit such withdrawals, so as not to drain your savings.
While you or your children can take out student loans, you can’t borrow for your retirement.
In the extreme, raiding your retirement funds to pay for college could mean running out of money in your later years — and forcing your offspring to support you.
“If you take out a significant portion of your 401(k) or IRA funds at an advanced age, you have less time to replenish, and if you come up short of funds at retirement, you have fewer options,” says Stephen Williams, senior vice president and the head of U.S. financial planning at BMO Private Bank in Chicago.
Because the interest rate on student loans is usually lower than the long-term average annual return of the stock market, it’s worth it to keep your money invested and have your children borrow for college, even if you later help them repay the loans, says David Royal, president of Thrivent Mutual Funds in Minneapolis.
“Helping your children with their college costs is a nice gesture if you can afford it, but you should likely not do it if it leaves you underfunded for your retirement years,” he says.
Clients who raid their retirement plans to pay for college are potentially missing out on the magic of compounding, says BMO’s Williams.
More specifically, paying for four years of college in effect could set a retirement saver back six to 10 years or more in building their account value, depending on market conditions.
Parents need to weigh that against their student having federal college loans at relatively low rates that can sometimes be deferred based on circumstances.
‘Should 529 money be invested in a target-date fund? If not, what is the best way to invest it?’
There are two ways to think about this.
Target-date funds—mutual-fund portfolios that usually start out with a mix of stocks and bonds and gradually move toward all fixed income as the beneficiary approaches college age—are easy: You pick one and never think about it again.
That is good for people who don’t want to do the research necessary to select funds for their 529, but not as good for those who prefer to have more control over their holdings.
“Decisions should be based on risk tolerance, holding period and the degree to which someone may wish to delegate the job of maintaining a portfolio allocation to a third party,” says David Macauley, college-planning program manager at Thrivent.
One downside to target-date funds, says BMO’s Williams, is that “if you miss out on a bull market that occurs shortly before the child goes to college when you are almost 100% fixed income,” you may wish you had more control rather than letting the target-date fund’s automatic glide path take over.
You also could be in the opposite situation of losing money while managing the 529 yourself, he notes.
‘Although we have had $350,000 in household income in recent years, next year our income will be under $40,000 due to retirement. I don’t think the Fafsa allows you to indicate extreme changes in circumstances. How can we get more aid for our two children, one in college and one in graduate school?’
“If your income situation changes drastically so that your income going forward looks very different than what is reflected on that applicable tax return for the Fafsa, you can reach out to the financial-aid office at your school to explain your new circumstances,” Macauley says.
Financial-aid officers are permitted to use their judgment when determining aid.
‘My daughter is in a graduate program that for one semester requires her to work, unpaid, four days a week at an elementary school across town. She takes buses or Uber to get there. Are the transportation costs incurred considered qualified expenses for 529 withdrawals?’
No. You can use 529 funds only for this short list of qualified expenses: tuition, room and board (if at least a half-time student), school fees, books, supplies and computers, Williams says.
If you choose to use 529 money for these transportation costs, you’ll have to pay income taxes on the earnings portion of the withdrawals, plus a 10% penalty.
‘If the owner of a 529 plan benefiting a grandchild needs the money for their own medical expenses, are these withdrawals qualified or allowed without penalty?’
No. You’ll have to pay income tax on the gains portion of any money you withdraw, as well as a 10% penalty, Macauley says.
‘I work for a private college. My daughter will receive tuition remission and be able to attend the college free. Would the tuition remission be considered equivalent to a scholarship? In other words, may I withdraw an amount equal to the tuition remission each year from her 529 account and not have to pay the 10% penalty?’
Yes. Tuition remission is treated the same as a scholarship, Williams says.
But although you are lucky not to have to pay her tuition, you’ll still have to cover the rest of her college costs, many of which do qualify as legitimate 529 expenses, including room and board, books, supplies and computers.
If there is money left over in the 529, you can direct it toward her graduate-school tuition, or change the beneficiary to any of her direct relatives and use the funds for their education without penalty, he says.
‘I am 10 years beyond retirement age. My longtime friend has a daughter in college who is a freshman with good grades, and I have been paying her full tuition. I am working to pay the tuition but would like to retire. My friend has no real assets and wouldn’t be able to pay. Can we apply for aid even though her daughter is already at the college and we never applied for aid before?’
Have your friend’s daughter file a Fafsa.
It doesn’t matter if this is her first time filing the form.
In your situation, your friend’s daughter should fill out the Fafsa using her parents’ income and assets, and indicate your contributions to her education as “other bills paid on my behalf.”
This money “will effectively be treated as untaxed income received by the student when calculating her eligibility for need-based aid,” Macauley says.