Most parents are happy to make sacrifices for their children. Many parents won’t hesitate to withdraw funds from their 401(k) to help their children pay for college.
Unfortunately, the drive to provide for the next generation can lead to major financial mistakes.
The Harm in Withdrawing Money from a 401(k) Account
Raiding a 401(k) is Expensive – Unless mom and dad are over 59 1/2, tapping into the retirement comes with an extra cost. Not only do they pay taxes on the money taken out of the 401(k) account, but they also pay a 10% early withdrawal fee.
The idea behind a 401(k) is to incur taxes when you have a much lower tax rate. If you are still working, your tax rate is much higher. Tack on the penalty for early withdrawal and the only winner with this option is Uncle Sam.
You can borrow for school, but you can’t borrow for retirement – Borrowing money for college sucks. This country is in the middle of a student loan crisis because too many people borrow money to fund educations that don’t justify the debt.
That said, the option to borrow money for college still exists. If you are short one semester, funds are available to pay for school. With retirement, no such borrowing option exists. This means work or go hungry.
Other Ways to Pay for School
Student loans are not the only way to pay for school.
Parents should be very nervous about student debt, but the answer is not dipping into their retirement. With resources like night classes, scholarships, grants, work-study, and in-state tuition, there are ways to pay for school without debt.
The notion of doing whatever it takes to attend a “dream school” can be a very expensive mistake.
Weighing Debt vs. Retirement Savings
Personal sacrifice for the good of the family is hardwired into the DNA of many parents. In this case, putting a huge dent into retirement accounts may actually be worse for the family.
Student loans are better than a defunded retirement – Depending upon your retirement investments, most people expect that their retirement accounts will generate a 7% interest on average. Student loan interest rates are much lower if you shop around.
Additionally, getting a student loan avoids early withdrawal fees and the taxes from pulling money out of a tax-advantaged account. Finally, your child has far more time to pay off student debt than you have to save for retirement.
The decision goes beyond finances – These decisions can easily lead to tension between family members. A parent who decides to delay retirement to help a child will likely be quite upset if the child decides that college isn’t for them after a couple of years of school.
Even if the decision doesn’t cause immediate issues, a delayed retirement could mean that a parent cannot help with childcare for the grandkids. Each household will have its unique hardships due to limiting retirement options.
Teach a Man to Fish
The best thing a parent can do for a child entering college is to teach them basic personal finance skills. One would think that these lessons should be taught in school, but they are not.
Understanding credit cards, compounding interest, mortgages, and credit scores is essential for a healthy financial future. If these lessons are not taught at home, they often have to be learned the hard way.
Funding a college education presents the perfect opportunity to put these lessons into action. It requires considering college options, major choices, and borrowing options. Once school starts, it requires responsible spending. Having frank, difficult conversations about college choices leads to smarter decisions and a lifetime of financial security.
A 401(k) is not a College Fund
Sacrificing your financial future to provide for your child’s education is a brave and selfless act. However, it is also ill-advised and unnecessary.
No parent wants to be a financial burden on their kids because their 401(k) is underfunded.
The best way to help is to encourage responsible borrowing. Plus, parents can always help repay student loans at a later date.
The early withdrawal penalty applies to withdrawals prior to 59½, not 65.
Doug, you are absolutely right, total brain fart on my part. Thanks for pointing that out!