Don't sacrifice your retirement to pay for college

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The skyrocketing cost of higher education coupled with a rising number of students has led to more and more parents taking out loans to pay tuition bills.

According to a survey by the College Savings Foundation, a Washington, D.C.-based not-for-profit organization with the mission of helping American families achieve their education savings goals, 44% of parents say they plan to borrow for their children’s education.* As more parents are borrowing, the average loan balance is also steadily increasing. The average loan balance has climbed from $18,550 to $28,950 from 2004 to 2014, according to an annual report issued by the non-profit Institute for College Access & Success.

You can't borrow for retirement

Be careful not to sacrifice your retirement savings to pay for your kid's college education. While it's a noble act to try to ease your child's debt burden, you could end up reducing the amount of money you have to meet your own expenses in retirement. You may even have to ask your child to help cover your expenses—creating a financial burden on the very person whom you tapped your retirement savings to help.

Also keep in mind that making withdrawals from retirement accounts to pay college tuition bills can have tax implications and possibly impact the student's Free Application for Federal Student Aid (FAFSA) calculation.

"Withdrawals from retirement accounts, including Roth IRAs, are counted as your student's untaxed income in the following year's FAFSA calculation," said Char Gross, who leads Vanguard Education Savings Group. "Student income weighs more heavily in the calculation, which could significantly increase the student contribution portion of your expected family contribution."

Conversely, if you take distributions from a 529 college savings account to pay qualified education expenses, FAFSA doesn't generally count those distributions as income for either the parent or the student.**

Avoid a higher tax bill

Withdrawals from your traditional IRA or 401(k) are counted as part of your gross income for that year. So along with owing more in income tax, those withdrawals could push you into a higher tax bracket.

If you're under age 59½, you'll also owe the IRS a 10% penalty if you take a hardship withdrawal from your 401(k), if your employer plan permits it. (The IRS allows you to use withdrawals from your IRAs, including small-business IRAs such as SEP and SIMPLE IRAs, for qualified education expenses without penalty.)

You have other options

There are alternatives to tapping your retirement savings to cover college costs.

  • Explore scholarships. Many schools and organizations offer scholarships. Grants and scholarships are considered financial aid but don't need to be repaid. The vast majority of students do receive some form of financial aid, including 70% who receive it in the form of grants and scholarships.
  • Use a 529 college savings plan. While starting early is beneficial, it's never too late to open or add savings to a 529 plan. Every dollar saved is one that you won't need to borrow. The earnings in 529 plans grow tax free from a federal tax perspective.*** Withdrawals are also tax-free provided they are used for qualified education expenses (tuition, room and board, books, computers, etc.). Some states' plans even offer a discount on your state income taxes for your contributions.

    Along with tax benefits, many of these plans give you access to high-quality, professionally managed investment options. Many plans offer age-based portfolios with a mix of stock, bond, and cash investments appropriate for each stage of your student's life.
  • Look at other schools. On average, state schools cost significantly less than private ones. And even private school costs can vary widely. The U.S. Department of Education's College Navigator has estimated costs for most colleges and universities in the United States. Focus on value for your dollar along with course offerings and comfort with the school's environment.

* Reality of college costs looms large, College Savings Foundation, 2016 Parents Survey

** Does a 529 plan affect financial aid?, Savingforcollege.com

*** Earnings on non-qualified withdrawals are subject to federal income tax and may be subject to a 10 percent federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.