As parents, we generally want to help our children as much as we can, through their formative years and beyond, so that once they are on their own, our children have the best foundation to build on. Oftentimes, at Henssler, we see parents who hate watching their children struggle with student loans. Inevitably, a few always ask about taking money out of their 401(k) to pay off their child’s student loan.
It is rarely ever a good idea to take a lump sum from your retirement funds to pay off your child’s student loans. Even if you have an old 401(k) from a previous employer that you’ve “forgotten” about or feel you have plenty of money for your own retirement, there are better ways to help your child financially.
First and foremost, when you take a lump sum from your 401(k), often, you will not receive what you think you will. If you currently work for the employer who sponsors the plan that you wish to withdraw from, you will be limited to the withdrawal options defined in the plan documents. Generally, most only allow for a loan that is capped at a specified percentage of your balance and must be paid back over time to avoid taxes and penalties. If you no longer work for the employer, you can withdraw your total vested balance, but be acutely aware that traditional 401(k) plan sponsors will withhold taxes for both federal and state income tax from the balance. In either case, if you are younger than 59 ½, you will be required to pay a 10% penalty for the early withdrawal.
For example, that $18,000 balance that you left in a former employer’s plan so long ago could cost you more than $7,000 in taxes and penalties. Furthermore, a significant withdrawal could bump you into a higher tax bracket. Also, depending on the amount, you may be required to file a gift tax return and use part of your lifetime exclusion to avoid paying a gift tax.
While your child may appreciate having his debt erased, he may miss the opportunity to write off up to $2,500 in interest paid on student loans on his tax return, even if he does not itemize his deductions. Additionally, by paying student loans regularly and on time, your child is building credit—something that will certainly come in handy when trying to rent an apartment or buy a car once your child is out on his own.
When choosing between paying down debt and investing, you should first compare what rate of return you can earn on your investments versus the interest rate on the debt. While it might seem counterintuitive, we generally recommend that you do not stop saving for retirement, and definitely do not stop contributing to your 401(k). So often investors halt their investing to pay down debt, but once the debt is paid, they get accustomed to a higher paycheck and never return to saving. Especially with low-interest rate student loans, it most often makes sense not to pull out your retirement money to alleviate the debt.
If you are currently saving to a brokerage account or emergency fund, you may consider working with a financial adviser to see if it would make sense to redirect some of your savings to help your child with the loans. If you want to be sure the money you pay on behalf of your child won’t derail your overall financial plan, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
