In today’s economic environment, most families are struggling just to keep their heads above water.
As we move left to right on the radio dial, station after station speaks of mass layoffs, yet another “necessary” corporate bailout, cutbacks in state-funded programs, increasing energy prices, representatives of the cabinet saying “give us more money” before the ink has dried on the last “let me reach a little further into your wallet” bill, or a senator saying that the taxpayer doesn’t care about the “porky little items” whose sum is in the billions of dollars. Obviously, this all comes from someone who is not spending their own money! Sheesh!
Amid all of this mess, families struggle with ways to come up with money to pay for college expenses. Prompted by a “sky is falling” mentality, many turn to retirement plans as a source of funds to help with these expenses.
But I implore you to calm down and step away from the retirement nest egg! Before you take a dime of your money out of your retirement accounts, let’s take a look at the very negative impact such a move could have on your family’s financial aid award.
The Use of Your Retirement Plan Money at Work- 401(k) or 403(b) Plans
Many people consider using money stashed away in their 401(k) or 403(b) plans to assist with college funding.
If your employer’s plan permits loans from your retirement accounts, the following facts might just have you leaping for that loan:
1) Loans are not taxed
2) You pay yourself interest on the loan
3) The money is readily accessible
4) Your plan may allow a maximum loan of $50K
Sounds pretty good!
But don’t forget to take the following into consideration prior to taking the loan:
1) Repayment terms – most plans call for repayment of entire balance within 5 years of loan.
2) If you lose your job, most plans call for repayment of the entire loan amount in 90 days.
3) When you repay the loan, you are paying with after-tax dollars. Remember, most of your contributions (if not all) were pre-tax contributions.
4) When you begin to receive payments from these accounts to supplement your retirement, the portion that was considered loan amounts will be taxed again. The IRS still considers these as pre-tax contributions and the appropriate tax rate will be applied. Yes, that’s right; you get to pay taxes twice!
5) You lose the potential growth of the funds in the account along with compounding effects.
Careful thought and consultation with your investment adviser or other qualified professional is highly recommended prior to taking money out of your retirement account to assist with college expenses. Make sure you understand both sides of the equation prior to using these funds.
So, how does the Federal Financial Aid System look at your retirement funds? I’ll give you a hint: some of their perspective may not be for the faint-hearted.
The balance of your retirement accounts, such as a 401(k), 403(b), SEP, Simple, Roth, traditional IRAs, Keogh or other qualified plans are not considered an investment (assumes financial aid application using the FAFSA; may not be applicable to institutions requiring the CSS Profile) and therefore are not subject to the corresponding (parental or student) asset assessment rate of either 5.65% or 20%.
If your plan at work has loan provisions and you are unable to pay the loan back, the entire amount withdrawn (less any amount repaid) will be reportable on your 1040 form, hence increasing your income. This increase in income will not only be assessed by the federal and state governments at the appropriate tax rate, but also by the Federal Methodology formula used to calculate your EFC. Assuming all other variables remain the same, the initial amount the government expects you to pay for your child’s educational expenses (EFC) prior to considering what they will pay, just increased.
For illustrative purposes only, assume you borrowed $20,000 from your 401(k) and were unable to pay back $14,000 of the loan.
If parental income is assessed at 42%, let’s take a look at the before and after:
Before 401(k) loan default After 401(k) loan default
COA $18,000 $18,000
EFC 6,000 plus 5,880 11,880
Need $12,000 $ 6,120
Assuming all other variables remain constant, your initial EFC increased by $5,880 ($14,000 x .42) which in turned decreased your need to $6,120. Ouch!
Since need provides the basis or starting point at which the government considers contributing to your child’s educational expenses, you have limited their potential participation by $5,880.
Keep in mind that the financial penalty pain doesn’t end there. You also have to consider the taxes that you will pay on the “withdrawn” amount. If your federal and state tax rate (ordinary income tax) is a combined 21%, you’ll pay $2,940 ($14,000 x .21) in additional taxes.
This does not take into consideration any penalties that may be incurred due to early withdrawal. These penalties may range from a low of 10% to a high of 25% (as is the case with an early distribution taken within the first 2 years from a Simple IRA) and are assessed on the full amount in question.
Using the example above and assuming a 10% early distribution (prior to age 591/2) penalty, an additional $1,400 ($14,000 x .10) would be owed to the IRS. This brings the potential grand total of taxes and penalties to $4,340 ($2,940 + 1,400), thereby eliminating thirty one percent ($4,340/14,000) of the purchasing power from the original $14,000 taken out of the 401(k)- YIKES!
The Down Right Ugly
In order to encourage individuals to save for retirement, the federal government does not tax contributions made to 401(K) or 403(b) plans up to a specified annual limit. Your contributions enter the retirement plan on a pre-tax basis; the tax man gets his cut as money is withdrawn to supplement retirement. If individual income qualifications are met, traditional IRA contributions are also deductible.
However – ah, there’s that dreaded “h” word – the Federal Methodology used to calculate your EFC looks at these contributions in an entirely different way. The financial aid system believes that you can stop contributing towards retirement and apply these contributions to college expenses. They anticipate you playing “catch up” with these contributions after your child graduates.
Accordingly, your pre-tax or deductible retirement contributions, are considered “untaxed income” by the financial aid system and are added back into the EFC calculation and assessed at the applicable rate. This assessment of your pre-tax retirement contributions begins during your child’s “base year” and continues with each year financial aid is applied for.
So let’s assume your family contributes $12,000 to retirement accounts and has a 42% income assessment rate for the year in question. The before and after picture would look like this:
Prior to Retirement Participation After Retirement Participation
COA $18,000 $18,000
EFC 6,000 plus $5,040 11,040
Need $12,000 $ 6,960
As you can see, the federal methodology increases your EFC by an additional $5,040 ($12,000 x .42) based upon pre-tax or deductible retirement contributions made for the year in question.
However, contributions made on an after-tax basis (non-deductible), such as to a Roth IRA or a non-deductible IRA, may have already been assessed (assuming contribution was made during your child’s base year or beyond) on the income side of the financial aid equation and are reflected in your Available Adjusted Income (AAI). Therefore, your EFC would not increase as in the example above by the assessment of “pre-tax” dollars.
Finally, if you are fortunate enough to work for an employer who has some type of “matching” program contained in your retirement plan, these employer contributions are also not assessed.
Now, before you rush to make changes to your retirement plan, let’s be clear: I am not suggesting in any way, shape or form that you discontinue your retirement contributions in order to pay for your child’s educational expenses. Quite frankly, I am on the other side of the spectrum, but I recognize that it is a personal decision. Therefore, at the risk of sounding redundant, please read the next two paragraphs closely.
As you make decisions regarding college financing versus retirement funding, you should carefully weigh how each decision will impact your wallet, both during your child’s college years and well into the future.
Putting all emotion aside, a possible question to entertain as you struggle with ways to handle college expenses for your child might be this: “How much will my child struggle with assisting me with my retirement?”
Now that you know how the formula used for federal financial aid assesses retirement contributions and withdrawals, you can plan accordingly.
And as always, be sure to consult with a qualified professional prior to incorporating any idea contained in this educational bulletin to insure proper application to your individual circumstances.