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[shellysmith1968@gmail.com]

I have a 401K. I've heard that it is not fully taxed if used for
secondary educational expenses. Are living expenses while attending
college counted? Does the penalty still apply?

[Steve Blank]

Shelly,

I'm afraid you've been given bad information. There are no tax breaks
for using a 401(k) for education. Any distribution is fully taxed, plus
has an extra 10% early distribution tax penalty if you are under 59 1/2
years old.

There is a small tax break for early distributions from IRA accounts.
There is no extra 10% penalty, but it's still fully taxed. And only the
amount used for qualified expenses - tuition and fees, but not room and
board, etc. - can count.

In any event, don't even think of making an early withdrawal from any
kind of retirement account if you have any other option. If you take out
say $10,000 you will pay tax on it (even if it's not subject to
penalty). Then when you apply for aid next year, that withdrawal will be
on your tax return as income and push up your Expected Family
Contribution (EFC), thus reducing aid eligibility for that new year.

Some rough figures to contemplate:

Assuming a 25% tax bracket, one pays $2,500 in taxes, plus state tax
(here in CT that would be another 4% = $400) so you've already lost
$2,900 of that $10,000. It's like taking a loan at 29% interest.

Then when you file next years FAFSA the added income can raise the EFC
by as much as about $4,000 depending on your bracket in the aid tables.

Now you've given up, in taxes and lost future aid, some $6,900, to which
you can add the 10% tax penalty ($1,000) if it was from a 401(k). Grand
total could be as much as $7,900 as the cost of that early withdrawal.

An awful expensive way to finance college - think of it as paying up to
79% on a loan. Your actual mileage will vary.

Then, of course, since your EFC went up and you may get less financial
aid for the second year, you may have to take even more out of the
retirement fund the following year, so you get socked again.

A further down-side, once you withdraw money out of a retirement
account, you can't put it back. So you're stealing from your retirement
as well.

Always explore other avenues first: loans of some kind (PLUS, on the
house, from a 401(k)[a loan, not a permanent withdrawal]), grandparents,
etc.


Steven B. Blank
College Financial Aid Consultants
29 Ives Hill Court
Cheshire, CT 06410
(203)250-7761