Employer-Sponsored Retirement Plans for Education Savings

Qualified employer-sponsored retirement plans are granted special tax treatment under the federal tax code. Profit-sharing plans and 401(k) plans are common examples of qualified employer-sponsored retirement plans. If your employer offers such a plan, this may be a way for you to access funds for your child's college education. However, it is usually not advisable to do so. The primary purpose of your retirement plan money should be to fund your retirement.

How do you access the money in your employer-sponsored retirement plan when you need it to pay college tuition?
Depending on the rules of your employer's plan and when your child is of college age, you may be able to access your savings in an employer retirement plan in one of two ways: borrowing or withdrawing.

Plan loans
Some companies allow you to borrow against the funds in your plan, as long as you have a vested balance in the plan. The amount of the loan you can take is generally limited to the lesser of $50,000 or one-half of your vested plan benefits. The advantage of plan loans is that they are not taxed or penalized like withdrawals, as long as the loan is repaid on time. Generally, you have to repay the loan within five years by making regular payments, at least quarterly. (The repayment period can be longer if the funds are used to purchase a primary residence.) However, if you leave your employer's service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you may have to immediately repay the loan in full.

Plan distributions
In limited circumstances, you may be able to withdraw funds from your employer-sponsored retirement plan to fund your child's education. Your first step should be to find out your distribution options. Your plan may offer several methods of taking distributions, or your choices may be very limited. Consult your plan administrator to find out which distribution options are available to you.

In general, you can take distributions from your retirement plan upon certain specified events. For example, you may be entitled to take distributions when you retire, or when you reach the plan's normal retirement age. You may also be entitled to take a distribution upon job termination, disability, plan termination, or financial hardship. Depending upon the type of retirement plan and the provisions of the plan, you may be eligible to receive certain distributions while you are still working for your employer as well as after your employment has ended. However, some plans may allow distributions only after your employment has ended.

Distributions you take from an employer-sponsored retirement plan generally must be included in your taxable income for the year received. Also, in many cases, you must pay a 10 percent premature distribution penalty tax if you are not at least 59¸ years old at the time of the distribution.

What are the strengths of using your employer-sponsored retirement plan to save for your child's college education?
Your employer may match your contributions
Some companies match the retirement plan contributions of their employees up to a certain level. If so, this is a significant incentive to contribute to the plan, since employer-matching contributions are essentially free money (once you are vested in those dollars). The more money your employer contributes on your behalf, the more rapidly your retirement plan balance is likely to grow.

Contributions are pretax
Most employee contributions to employer-sponsored retirement plans are made on a pretax basis. In other words, your contribution is taken from your salary and invested in the plan before income taxes are withheld. This has the effect of reducing your taxable income, allowing you to pay less income tax each year.

Growth is tax deferred
Your contributions to an employer-sponsored retirement plan grow tax deferred. This means that the earnings on your plan investments are not subject to income tax as long as they remain in the plan. Those earnings will be taxed only when you begin to take distributions from the plan. In the meantime, your plan funds have the opportunity to grow more rapidly than they would in a taxable investment account (depending on the performance of the plan investments).

The federal government does not consider the value of your employer-sponsored retirement plan in determining your child's financial aid eligibility
In its formula for financial aid, the federal government counts some assets and excludes others in determining a family's total available assets to put toward college costs. One asset the government excludes is retirement plans (both employer-sponsored retirement plans and IRAs).

Example(s): Assume that the Reed family has $60,000 saved in Mrs. Reed's employer-sponsored retirement plan and $30,000 in stocks. Under the federal government's formula for financial aid, the Reed family's total assets are considered to be $30,000.

Caution: Though the federal government does not ask how much money you have in employer-sponsored retirement plans, it does care about how much money you contribute to an employer retirement plan in the year before you fill out the Free Application for Federal Student Aid (FAFSA). If you contribute money to an employer-sponsored retirement plan in the year prior to the year you complete the FAFSA, this contribution is considered discretionary and is added back into your total income for the year.

For more information on the federal government's formula for financial aid, including what assets are excluded from consideration, see Applying for Financial Aid.

What are the tradeoffs of using your employer-sponsored retirement plan to save for your child's college education?
The 10 percent early distribution penalty applies to most distributions made before age 59¸
No premature distribution penalty tax applies when you take a distribution from a traditional IRA or Roth IRA before age 59¸ to pay for the qualified higher education expenses of you, your spouse, or the child or grandchild of you or your spouse (for more information, see Traditional IRAs and Roth IRAs). However, Congress did not extend this treatment to employer-sponsored retirement plans.

As a result, if you take a distribution from your employer-sponsored retirement plan before age 59¸ for college-related expenses, the taxable portion of the distribution will generally be subject to the 10 percent premature distribution penalty tax. This penalty tax would be in addition to ordinary federal (and possibly state) income tax on the distribution. If the amount of the distribution is large, it could result in a significant income tax liability. It could even push you into a higher income tax bracket for the year of the distribution.

Due to the tax implications of taking distributions from an employer-sponsored retirement plan, a plan loan (if available) is almost always the better option.

Your retirement nest egg is reduced
Any money that you distribute from your employer-sponsored retirement plan reduces the amount of money that will be available to you when you retire. Depending on your financial situation, this could jeopardize your ability to reach your retirement goals. Even when you borrow money from the plan, there is still less money available to reap the potential benefits of tax-deferred growth. For these reasons, you should try to use other accounts or sources of funding to finance your child's education.

You may not be working for the same company when the time comes to access the funds
In today's environment, it is not uncommon for a person to have several different employers (perhaps even several different careers) over the course of his or her lifetime. For example, you could start contributing to an employer-sponsored retirement plan when your child is 6 years old, and then find yourself working for another employer with no retirement plan when your child is 17 years old. In this case, you would probably need to roll your plan funds over to an IRA, because if you leave the funds in your previous employer's plan, you may not be able to borrow those funds (because you are no longer an employee of the company).

Tip: If you do roll the money over to an IRA, you will be able to take a distribution prior to age 59¸ to fund qualified higher education expenses, without being subject to the 10 percent premature distribution penalty tax. For more information, see Traditional IRAs and Roth IRAs.

Colleges may consider the value of your employer retirement plan before awarding their own financial aid
Although the federal government does not consider the value of your employer-sponsored retirement plan in determining your child's eligibility for financial aid, individual colleges may consider the value of such accounts in determining whether your child is eligible for campus-based aid. Many colleges consider the value of such plans (along with IRAs) crucial to accurately measuring your family's ability to pay, and the colleges may expect you to borrow against them before institutional aid is forthcoming.

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