Should I use my 401(k) to fund my child's college education?

Answer:

Yes, but it isn't the best option. A 401(k) plan should be dedicated primarily to retirement.

There are two primary drawbacks to using a 401(k) for college funding. First, if funds are withdrawn from a 401(k) before age 59½, you may owe a 10 percent premature distribution penalty on the withdrawal. This penalty is in addition to income taxes that will be owed on the withdrawal. Second, frequent dips into a 401(k) reduce the amount of money you ultimately have available to reap the benefits of compounding and tax deferral. This, in turn, reduces the overall funds for retirement.

If a 401(k) is really needed to pay for college, a better option might be to borrow from it if the plan allows loans. Plan loans are not taxed or penalized, as long as they're repaid within a specified time period. But be sure to compare the cost of borrowing college funds from a plan with other finance options. Although interest rates on plan loans may be favorable, the amount that can be borrowed is limited, and the loan generally must be repaid within five years. In addition, some plans require that the load be repaid immediately if you leave your job. Retirement earnings will also suffer as a result of removing funds from a tax-deferred investment.

To save for college in a retirement vehicle, consider using a traditional IRA or Roth IRA instead. With these IRAs, you will not owe the 10 percent premature distribution penalty on withdrawals made before age 59½, as long as the money is used to pay a child's qualified college expenses. If you have some time to plan a child's college fund, consider a Coverdell education savings account or a 529 plan established and maintained by a state or eligible educational institution. Each of these vehicles is specifically geared to college investors and offers numerous tax advantages.

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