You Might Have Options
If you want to use your 401k account to take withdrawals for education expenses for you or your children, there are a few things that you need to know about withdrawals for education from a 401k plan.
First, withdrawal options vary from plan to plan. A distribution that one play may allow another may not, so there is no guarantee that you have access to your 401k money. Most people do, however, so I will highlight the most common options that may be available to you to pay for education expenses from your 401k.
The first option that you may have is to take a 401k loan. A 401k loan is just like any other loan you might take except that you are taking the loan from your own 401k money. Also, you are paying back principal plus interest to your own account. As long as you make the payments on time there is no tax consequence of taking a loan from your 401k. You can use 401k loan proceeds for any reason, including education expenses for you, your spouse, or your children.
The good thing about taking a 401k loan for education expenses is that you don’t need approval from a bank. The bad thing is that you are taking money out of your 401k is that the money is no longer in the market so you are missing out on the time value of money.
You will typically pay an interest rate on a 401k loan of around prime + 1% or so, though it will vary from plan to plan. You are also limited on what you can borrow as there is a minimum (typically $1,000 or so) and a maximum (typically $50,000) that you can borrow. You can only borrow 50% of your vested account balance as well, so to get the full $50,000 you will need a vested balance of at least $100,000.
401k Hardship Distribution
Your plan may allow a hardship distribution. Among one of the permissible reasons that a participant could take a hardship distribution, if allowed, is to pay for tuition and related educational fees and expenses. This includes expenses for the participant as well as the participant’s spouse and dependent children, so if your plan allows you can use a hardship distribution to pay for education expenses.
To get a hardship distribution you will have to apply with your employer. Your employer will have the burden of proving through facts and circumstances that they get from you that you really need the money. If you have another practical way to pay, they can deny your hardship request. If it is determined that you have no other options and the hardship is the only way, you are likely to be approved.
Unlike a loan, you don’t pay back a hardship distribution. That means the money is gone form your 401k forever, so it won’t be there for you in retirement. The rationale that you must believe is that the education is worth more than this distribution from your plan. Your maximum hardship distribution will be the amount that you have elected to put into the plan over time, so it will be different from your real balance.
A hardship distribution 401k withdrawal for education will be taxed. It will be considered ordinary income to the participant in the year taken. You can expect 20% to be withheld right away and the rest will catch up with you at tax return time. In addition to that, if you are less than 59.5 years old an extra 10% penalty will apply when you file your tax return for that year. One other important thing about taking a hardship distribution is that your plan may require you to stop making contributions to the plan for a period of time, typically 6 months.
401k Regular Distribution
Unlike a hardship distribution, there is no application process that is subject to the verifiable education expense need made by the employer. In this case, a simple distribution application or even an online form is all that is needed.
If a partial distribution is an option that may be the best way to go. This way you can avoid taxes and penalties on the bulk of your account while getting the money from 401k needed for education expenses. If that is not an option, you may still be able to have a check cut to you for the education expense and the rest paid to a rollover institution so that you can rollover most of your balance without taxes or penalties.
Distributions will be treated as ordinary income in the year taken, so expect 20% to be withheld right away before you get your check and the rest will be taxable when you complete your tax return. Like the hardship distribution, if you are less than 59.5 years old you will be subject to an extra 10% tax when you file your tax return for that year as well.
Those are your primary options for taking 401k withdrawals for education. For your retirement fund, it is best to leave the money in your plan so that it is there for you retirement, but if you have no other option and your plan allows, a loan, hardship, or distribution may work for you.
To find out which options apply to your plan check your 401k plan website or summary plan description. If you don’t know how to get access to your site and you don’t have a copy of the summary plan description, check with your employer and they will be able to tell you what is available and what the application process involves.