For most families, a 529 plan on its own is not enough to cover the out of pocket expense of college. The number of years to save for college is short and every dollar is stretched thin for young families, and many young parents still have student loans of their own that they are paying on.
Yet, normal families across the country are figuring out how to pay for college without going broke or taking on insane amounts of debt. A well thought out college funding plan will always include a smart college choice, cash flow and tax planning, and smart lending strategies.
Is it ever a good idea to tap retirement and home equity?
When faced with the high cost of college, parents may be forced to consider using their retirement or home equity to help pay the costs. Choosing these options should be done as a last resort.
Preserving your retirement assets and retiring mortgage free are high priorities. College should not be looked at in a vacuum. Good financial planning is about choices and understanding the trade-offs that you are making if you raid your retirement or home equity. You will either need to work longer, or retire on less. Just be sure you understand the long term impact on your overall financial plan.
Let’s look at your home equity first
A home equity line of credit (HELOC) is money that can be borrowed against the value of your home minus any other outstanding mortgage amount. In order to qualify, consumers must have enough equity in the home, a high credit score, and a good debt to income ratio. For HELOCs, typically lenders want the loan to value (LTV) to be 80% or less.
A HELOC is a mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate. You only access the funds that you need when you need them. For consumers with good credit the interest rate available via a home equity line of credit may be more favorable than the rate from a Federal Parent PLUS loan or a private student loan.
But here’s the deal, do you want to put your home at risk to pay for college? The Parent PLUS loan may have a higher interest rate, but it comes with some perks like loan deferment and flexible repayment options that a home equity line of credit does not. A home equity line of credit should only be used for small funding gaps. This is the same guidance we give for the Parent PLUS loan--to cover a small gap.
Also, be aware that if you take out a home equity loan or line of credit and the money is in your bank account when you complete the FAFSA, it will be counted against you as an assessable asset in the financial aid calculation. Those who may be eligible for need-based financial aid do not want the money from their home to be sitting in their bank account when they fill out the FAFSA.
What about those retirement funds?
Even if you are not yet 59.5, you can take distributions from your IRAs for qualified higher education expenses without having to pay the 10% additional penalty tax. The funds must be used for yourself, your spouse, your child, or your grandchild. The funds must be used for qualified expenses like tuition, room, board, and necessary fees. The student must be enrolled more than half-time to qualify.
If you use a Roth IRA, you can avoid the 10% penalty if the account has been open for at least five years.
Traditional IRA withdrawals will be subject to federal and state taxes. Withdrawals from a Roth IRA used for higher education can be free from tax liability if you limit the withdrawal to an amount up to the amount you contributed.
Money in an IRA is not counted in your assets on the FAFSA. In other words, retirement money does not count against your need-based aid calculation. However, withdrawals from an IRA will be counted as earned income the following year. This income can be assessed as high as 47%! So, taking a $10,000 distribution from your traditional IRA could increase your EFC (expected family contribution) by as much as $4,700 the following year. If tapping your retirement funds is a necessity and you are a need-based candidate, choosing to do so in the final/senior year typically will not affect your financial aid.
A Roth IRA and a 529 plan could both be considered tax-deferred savings options for college. However, because contributions to an IRA are limited every year ($5,500 per year/$6,500 age 50 years or older), a 529 plan is still a great savings vehicle if using those funds to pay for college is your intent.
A blended saving strategy that balances tax advantages and flexibility upon distribution is important to consider. Frequently this is a combination of Roth IRA, 529, and tax efficient mutual funds.
But here is a key question you must consider; do you want to risk your retirement? Yes, paying for college is a huge bill, but you have many options available to help you. Can you get a loan to pay for college? Yes. Can you get a loan to pay for retirement? Not really. So, making the decision to use retirement funds to pay for college should be done with careful consideration.
In general, we always stress a blended approach to incorporate smart college choices, cash flow options, tax planning, student loans, work-study, and only tap retirement and home equity to fund a small gap. Understanding the impact on your retirement and taking a holistic approach is always the wisest course.