Can You Borrow From Your Retirement Account to Pay for College?

Some retirement accounts allow you to borrow to pay for college.
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It can be a difficult task for many families to save for both college and retirement. Since both of these goals usually compete with each other, one of them is often sacrificed -- to some extent-- for the other to be achieved. Some companies offer 401(k) plans that allow workers to borrow from their own retirement accounts to meet major expenses, such as paying for higher education. Other types of retirement savings, such as IRAs, are strictly off limits for taking out loans for any reason. But then, borrowing from a retirement account is usually not a good idea anyway.

Not Required

Although the Internal Revenue Service allows workers to borrow from their company 401(k)s, companies are not required to offer loans as an employee benefit. Some smaller companies have established 401(k) plans as a way to help employees meet their retirement goals. But companies are required to follow strict IRS guidelines when they offer 401(k) loan programs to employees, and sometimes companies are not able to afford the administrative costs of managing an employee loan program.

Loan Limits

The minimum amount you can borrow from most company plans is usually $500 to $1,000, which should be enough if you're only buying college textbooks. But if you need more cash for college, company plans usually allow you to borrow up to 50 percent of your vested balance or a maximum of $50,000. Personal loans, which include loans for college costs, have a maximum repayment term of five years. The loan must be repaid in equal installments taken directly out of your paycheck. The interest rate you pay back to yourself is usually the prime rate plus 1 percent.

Taxes and Penalties

If you take out a loan from your 401(k) to pay for college, you will face taxes and penalities if you leave the company before the loan is repaid. IRS rules require employees who quit or get terminated from a company where they have an outstanding 401(k) balance to repay the full balance within 60 days of leaving the company. After 60 days, any unpaid loan amount is treated as a distribution and you will have to pay income taxes on that money at the ordinary tax rate. If you are less than 59 1/2 years old, you'll also owe the IRS a 10 percent penalty for taking an early withdrawal.

Opportunity Costs

Taxes and penalties don't really reflect the true costs of your 401(k) loan. You also have to consider the future income that money could have generated through compound interest over the years. When you take out a loan from a retirement account, you also are making a decision to surrender the future investment income that would have been generated with the money you borrowed. If you happen to take out a loan when the stock market is at a bottom and it goes up, you'll do even more damage to your retirement nest egg, because you would have taken money out at a low point and you'll be repurchasing the investments at a higher price as you repay the loan.

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