Strategy to use HELOC then repay from 401k after age 59-1/2 & student graduation.

Paying for College
1

My wife and I have two kids who will shortly be off to college. The oldest will start this fall. She has some great acceptances with grant aid bringing our cost to the FAFSA EFC, but we can’t actually pay that much out of our salary income.

Brief summary of my plan to pay for their undergraduate education:
Borrow up to $120,000 total from HELOC (Home Equity Line Of Credit) spread over the next 6 years to pay for 2 kids’ college. After graduation and parents have hit 59-1/2 years old, pay HELOC off with 401k funds.

I’d appreciate input from those who have been down this path before.

More detail:
We have two future college students- one will start this year (2019) and the other in 2 years (2021).
My goal is to help them so they receive their bachelors degrees without significant debt.
To accomplish this I anticipate needing up to $120,000 beyond what we can pay out of our annual income.

There is of course uncertainty, but I think $120,000 is the upper bound. Hopefully it will be quite a bit less. Oldest has some great acceptances but we are waiting for final aid letters. Youngest has excellent prospects too- we anticipate he will also get some “full need met” offers.

We’re rather “cash poor” and don’t have liquid assets to cover this amount. We do have more than enough surplus funds in our 401k plans. I looked into drawing directly from the 401k, but it may be subject to a 10% tax penalty if withdrawn prior to age 59-1/2. It would also be added to our regular income on the FAFSA and therefore increase the EFC for following years.

We have plenty of equity in our home to borrow the needed funds while staying well below 70% Loan To Value. Our credit union’s current rate is 5.75% for HELOC. We could write checks directly from the HELOC to the university.

We will hit 59-1/2 in our youngest child’s 4th year of college. After that age threshold and and the final FAFSA is done, we would pay the HELOC off from proceeds of the 401k accounts. This would probably be spread over a couple years to avoid getting bumped into a higher tax bracket.

In case you’re concerned, this is just a portion of the 401k’s and we also have a very good defined benefit pension plan which will be sufficient for our retirement income.

Please let me know if I’m missing a fatal flaw in this plan.
Thanks

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fatal flaw in this plan.<<<<<<<<

What affordable school options do you have?

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Remember also that under the new tax law, you cannot deduct the interest paid on your HELOC if it’s used to fund college.

4

Sybylla,

Not really the point of my question- I believe the schools in consideration are very reasonable. We want our kids the opportunity to go away to quality schools. Our EFC is in the mid 20’s and the one private school that has provided their financial aid letter matches this between grant and guaranteed on-campus employment. She has been accepted to several public schools both in and out of state and the cost of attendance for those would be about $5,000 more than the private. Since our son’s situation is still unknown, I estimated the upper limit of borrowing needs assuming we would need an extra $15,000 per kid per year.

5

It sounds like you expect to need $15,000 each of the first two years for your first child. The 3rd and 4th years you will have 2 in college, so your portion of the EFC will be split between the two. Assuming both attend schools that meet need, you would need $15,000 each of those two years, not $15,000 per child. That’s the good news.

Have you looked into the interest rate if you borrow the money from your 401K? While that could get you into trouble if you suddenly lost your job (repayment would come due, or it would be deemed a distribution). As a loan, it would not add to your income. If you do end up taking out of your 401k, you can avoid the 10% penalty by rolling it into an IRA first. You might consider doing this doing this to pay your younger child’s last 2 years, as income from those years will not be used to calculate aid for future years (final year 2024-2025 aid will be based on 2022 taxes so you can afford the higher income in 2023 without impacting aid).

6

You will have to make payments on your HELOC until you can take the 401k withdrawals without penalty. If you are cash poor now, how will you do that?

7 
     Is that a competitive HELOC rate? It seems so high if you have a lot of equity? And this scenario includes the direct loans? What is your mortgage interest rate?
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One thing to consider, if you borrow from your 401k (contributed with pre-tax dollars) is that you are paying back the loan money from your after tax dollars which in the long run is going to cost you a lot of money.

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Not a terrible plan, thoughts are as follows:

Can’t deduct HELOC interest (for federal tax purposes).

Assuming you have enough extra cashflow to service the debt on the HELOC?

Payback with 401(k) or IRA money will be a little painful, as you’ll have taxable distributions. So you’ll need to pull out $150K (or something depending on your tax rate) to get the $120K you need.

If a 401(k) loan is available it could be a better option.

10

Thanks for the responses. They made me think a little harder. I am trying to prepare conservatively for worst-case.

401k loans from our plan are limited to 5 years duration and we can only do one at a time. It doesn’t fit our needs.

The nice thing about a HELOC is we can write checks for school costs so only have to pay interest on the exact amount from the exact date needed. We can make interest-only payments during the draw period or effectively avoid all payments by pulling out extra to equal the interest payments. We will shop HELOC rates and terms. Our credit union has great terms and no upfront cost but maybe their rate is less competitive at US Prime +2%.

Of course we would pay taxes at a high marginal rate when withdrawing from the 401k. That was the bargain when we made pre-tax contributions.

Using a reverse-mortgage calculator and assuming a flat $20k/yr draw for six years with all interest accruing we would owe about $140k at the end. With current federal and california tax rates, I estimate it would take about a $175k draw from the 401k to pay this off. It’s a lot of money but I think well spent- especially since it would be all done with before I retire a few years later.

Regarding cost with the second child in school- I’m trying to use a fairly pessimistic forecast. If both kids take a merit scholarship instead of need-based then the individual prices wouldn’t drop when both are in school at the same time. If both have great need-based scholarships then it will be better.

It’s also hard to estimate our household cost changes when kids are off to college. Obviously things like groceries and utilities go down, but we might spend more on travel with many cross-country trips.

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@JimQPublic - it’s reasonable - we actually saved our college funds in my spouse’s 401K because he turned 59.5 before our eldest went to college. The only drawback to withdrawing from the 401K after 59.5 and while you are still working it those with drawals are taxed at your highest marginal bracket. If your joint income is below 137K the fed tax rate will be 24% for that 20K and CA adds another 9.3%. That means anything you withdraw will be hit a 33.3%. 140K/.666 = 210K, not 175K. If your joint taxable income goes any higher than that the bracket jumps and every penny you withdraw gets taxes of 40 cents on the dollar. So you are right about spreading out the payments, they might just need to be spread out more than you planned and unless your income is under 40K a year I think you’ve underestimated the net impact to your 401K.

One additional thing to look at might be how to improve your cash flow so you are spending less of the $ you earn annually on other usual expenses and reducing the money needed from your 401K. Our various ways of improving the cash flow were: we stopped contributing to the 401K plans two years before my eldest D went to college, we refinanced our house with an interest-only mortgage so we only paid (deductable) interest, we changed our medical plan to a lower premium plan. Every penny you earn and don’t spend helps with the 401K marginal taxation problem.

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@CaMom13 My bad on the math. Not sure how I got $175k. $210k yikes!

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@JimQPublic
“I estimate it would take about a $210k draw from the 401k to pay this off.”
have you run retirement calculators to see if you CAN live comfortably over the next 30+ years of retired life with $210,000 less in initial savings?? that’s a LOT of $$.
THAT is the first thing I would do.
https://financialmentor.com/calculator/best-retirement-calculator

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Is the DB pension with a current solid employer? Big corporate or govt?

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Yeah @JohnQPublic - that top bracket hurts! We are feeling the pain now. I would make sure you aren’t better off doing a home refinance where the interest amounts are deductable and save you tax dollars. Ultimately if you end up with 120K higher home mortgage and 210K more in your retirement account you probably are better off than the other way around.

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Could you do the 401k loan & then pay it off in 5 years with the heloc? Then pay the heloc with the 401k distributions after 59 1/2?

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I also wondered about a refi, you have 6 yrs until you are 60? How many years are left on the mortgage and at what rate?

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It is a LOT harder to refi these days than it once was.
Even Ben Bernake was not able to get a mortgage on a home he wanted to buy not long ago.

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@Sybylla I suppose we might consider refinancing when we’re done with the college expenses. I think a HELOC or similar loan is better now because we would only pay interest on the money borrowed. If we did a big cash-out refi at the outset, then we’d pay interest on the whole bundle from day one. Our first mortgage is at a lower rate than currently available.

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Why do you think you’d only pay the interest on the amount borrowed? For how long? It doesn’t seem like a good idea to borrow $20k every year for 6 years and never start repaying the principal for 6 years.