401(K), 403(B), SEP, KEOGH, SIMPLE IRA and other retirement accounts are alternative investment choices for education funds. Their primary advantage is that their earnings growth is tax deferred until amounts are withdrawn from the plans and there is a tax deduction when contributions are made. For most people, however, the potential cost of withdrawals is too expensive as they are subject to a 10% early distribution penalty if amounts are withdrawn before the owner reaches age 59½.
The 401(k) maintains a slight advantage over the other retirement accounts in that some companies match employee contributions up to a certain level. In a sense, the employer can help contribute to your college fund. However, you need to be cognizant of the following factors:
- Any amount over the employer matching contribution may be better invested in other areas.
- Be sure the 401(k) has a large number of investment choices so the investment can be well diversified, especially as the student approaches college age.
- Be sure the company has a review process whereby the investments are allocated for maximum return compared to the investment market in general.
Some families may consider saving for college through their retirement plans.
The advantages to using this form of college savings are:
- non-assessment in the EFC calculation,
- contributions are tax deductible, except in the case of Roth IRAs and non-deductible IRAs,
- tax-deferred growth of earnings,
- availability of loans from the account, except for some types of retirement plans (e.g., IRAs and Keogh plans) during college years,
- depending on the type of account investments, the ability to keep up with the high college inflation rates,
- the account assets are sheltered from creditors,
- IRA withdrawals (including Roth IRAs) before age 59½, used for qualified college expenses, are not subject to the 10% early withdrawal penalty, and (8) the employer may match contributions to some plans.
Caution: There are some possible disadvantages to using retirement accounts as an investment vehicle to save for college.
The possible disadvantages are:
- conversion of low-taxed capital gains into high-taxed ordinary income,
- a 10% penalty for withdrawals (except in very limited situations) before the age of 59½,
- retirement funds needed for future retirement may be depleted to pay for current college costs,
- immediate repayment of outstanding loans may need to occur if there is a job loss, and
- outstanding loans may be considered withdrawals and produce taxable income and the 10% early withdrawal tax penalty, if they are not repaid within 5 years.