Though you might have put money into your 401(k) plan with the expectation you weren't going to touch it until you retired, you might find yourself wondering if you can access some of the money for college tuition. Whether you're going back to school yourself or you have a child ready to leave the nest, your 401(k) might be a source of funds you can use, but how you access the money has a significant impact on the tax consequences.
If you're over 59 1/2, you can withdraw money from your 401(k) plan whenever you want. If you haven't reached that age, however, you're able to withdraw money only under limited circumstances, including if you've left your job and are 55 or older or if you have a financial hardship. The IRS requires that you have an immediate and heavy financial need, but allows each 401(k) plan to decide for itself what qualifies. So, depending on your plan, college tuition might be a permissible reason for a hardship distribution. But, if it's not, you can't withdraw from your plan to pay for college.
Tax Consequences of Withdrawal
When you take money out of your 401(k) plan, you must include it as part of your taxable income -- even if you're over 59 1/2. The advantage to waiting until 59 1/2 is that you can take the money out for any reason and not be required to pay an additional 10 percent early withdrawal penalty. Though the IRS does recognize a few exceptions to the penalty, there is no early withdrawal exception for higher education expenses, so if you tap your 401(k) for college tuition, you owe income taxes and a 10 percent early withdrawal penalty, even if it qualifies as a financial hardship.
401(k) Loan Alternative
The IRS also permits plans to allow loans from your 401(k). It's up to each plan, so if your plan doesn't allow loans, you're out of luck. But, if loans are permitted, you can borrow up to $50,000 or half your vested account balance, whichever is smaller. You can use the proceeds of the loan for any purpose, including paying college tuition. Then, you repay the loan through paycheck deductions over five years. Though you have to pay interest on the loan, that interest gets put back in your 401(k) plan.
Loan Tax Implications
Loans don't count as taxable distributions from your 401(k) plan, which means you won't owe income taxes or the early withdrawal penalty when you take out the money. However, if you default on the loan, including not paying back the loan immediately if you leave your job, the remaining balance does count as a taxable distribution. For example, say you borrow $10,000 for college tuition. After you've paid down the balance on the loan to $8,000, you're fired and you don't repay the balance. That last $8,000 counts as taxable income and is hit with the 10 percent early withdrawal penalty.