My husband and I are both in our 40s and we are wondering if it makes more sense to borrow for college against our retirement accounts or take out a student loan for our daughter.
Taking out a student loan makes much more sense than borrowing from your 401(k). Most parents have a tough time choosing between saving or financing their children's education and saving for their own retirement. Because most people cannot live on Social Security alone, building an adequate nest egg should be a top priority. Here are some of the risks of borrowing from your 401(k):
- If you leave your job, you will have to pay back that loan immediately. If you don't have the funds to do so, you will trigger taxes, and incur a 10 percent penalty if you are under 59 1/2 years old.
- You are giving up the tax-free compounding of the money you withdraw. Use the online “spend it or save it” calculator in the retirement savings section of the website site www.360financialliteracy.org to determine the impact of not having that amount of money in the plan for the term of the loan -- usually five years -- and then the compound effect of those lost earnings from year five until retirement. Because you can borrow up to $50,000 or 50 percent of your 401(k), whichever is lower, the lost earnings toward your retirement will be significant.
- Even though you will be paying yourself back interest on the 401(k) loan, that interest is not tax deductible. The interest on a student loan is deductible up to $2,500 per year, even if you do not itemize, provided that your adjusted, married filing jointly income is below $130,000.
- Student loan interest rates can be lower than the interest rate charged on a loan from 401(k) plan.
Should you decide to take out a loan for education, consider having your child take out the loan instead of the parent. Student loans have the lowest interest rates, best repayment terms, and are deferred until after graduation. You can always help your child pay back their loan over time, which will allow you to keep your existing retirement nest egg in tact.
Answer By: Virgil A. Kahl, CPA, is a certified financial planner with Spring Ridge Financial Group in Wyomissing.