Some 401K plans allow for “Hardship Withdrawals” to pay for a child’s tuition, as opposed to a loan that needs to be paid back. Two caveats - (1) obviously there’s a tax implication, and (2) if the hardship withdrawal is for college tuition or related costs, it’s only good for the first year of school; has to be used within a 12-month period.
@BivalentChomps The two problems with “hardship withdrawals” is they may still be subject to the 10% tax penalty and they show up as income so the next FAFSA will show higher income and higher EFC.
@twoinanddone I’m not convinced it’s a good idea to let interest compound against us. This is an exercise in looking at the most conservative “worst case”.
One thing to consider is that my 401k will (hopefully) keep appreciating at a rate equal to or greater than the interest rate.
Retirement funds withdrawn (prior to turning 59 1/2) to cover college expenses are not subject to the 10% penalty. However, the money is recognized and taxed as income. http://www.finaid.org/savings/retirementplans.phtml.
HELOC rates should be close to prime (5.25%) if you have plenty of equity and a high credit score. Some are slightly below that (lowest we found was prime minus 0.3%).
Otherwise sounds like a good option to withdraw as you need it, especially as you wouldn’t want any assets to count against you for need based aid. A HELOC can enable you to have virtually no cash in your bank/savings account on the date you complete the FAFSA by temporarily paying off part of the loan with those savings.
I wasn’t questioning whether only paying the interest as it accrues was a good idea but whether it would be allowed at all. I know some people who repaid interest only on their first mortgages but there was always a balloon at some point - 3, 5, 7 years out. I’ve never seen a HELOC set up that way.
Did you calculate the monthly payments on the heloc and can you afford those, on top of tax bites? 20k seems to be a little more than 200/month repay. It only goes up as you take more. So you’d want to play out your calculations for each of the 6 years. Including taxes and any effect on future FA.
Paying interest alone seems to keep monthly down at first. But you’re left with the big nut, which remains years later. Then you dig into the 401k, at what could be a vulnerable time. You might continue working or something else could happen. Without one income, could you or your spouse manage? You could have that 100-200k debt, lower income, and a higher need for those 401k funds.
Sorry. That’s the problem with large $ forward financing ideas. You know what might work today, not what could happen and projecting the strain. You’re closer to retirement than a lot of parents on CC.
Again, are you having the kids take the direct loans? did I miss that bit?
@twoinanddone You have to pay the interest on a HELOC during the draw period but there’s no limit on the number of withdrawals. So you can take another advance from the HELOC to cover the interest charge if desired. The draw period can be 5 or 10 years.
The big risk with HELOCs is that as some people found out in 2008-09, the bank has the right to freeze them if circumstances change (e.g. your house price declines or you lose your job). That means you could find the money is no longer accessible at a time when the stock market has melted down and your 401(K) is not worth what it once was. If you can’t afford to pay the interest without further draws then that can be a major problem.
Not all HELOCs are set up the same way. I worked for a lender and we only allowed 4 draws and the period was much shorter than 5 years. We found most customers only took 2 draws, the first one when they took out the loan and a second one shortly thereafter.
I’ve just never seen one where the person didn’t pay principal on a regular payment schedule. If the OP set up a $120k HELOC, he could take $100k the first day and pay no principal at all for 10 years if the never took the final $20k? That’s not good lending. That’s 2005 lending, leading to a big crash.
401(k) loan should be the last resort. I’m looking at this purely from tax perspective. You will incur double taxation when doing so. Below is a simplistic example:
Now - you borrow $100,000 and your current marginal income tax rate: 30%. The income tax for that 401(k) loan is $30K.
Then you have to pay back the loan.
When you retire and your marginal tax rate is 20% (lower since you no longer work) - when you withdraw $100K, you’ll be taxed again at 20%, or $20K.
Total potential tax paid: $50K. And that doesn’t include the potential 10% tax penalty.
There is a difference between a 401k loan and a withdrawal. If you take a loan, you do not have a 30% tax now; there is no tax due now for a loan, and no penalty.
@twoinanddone - You’re right! I was mixing up between a 401k loan and a withdrawal. I was reading some previous comments about hardship distribution so I was thinking about it at that time…
Re. 401k loan, there are many drawbacks that have been mentioned. If I need money to fund for college, I’d rather use a HELOC. The rate of returns on my current 401(k) will more than offset the interest rate expense for the HELOC.
Re @socaldad2002 #7
This is a misconception that I have read a lot.
If you take ANY loan from ANYWHERE, you have to pay it back with after tax dollars. So a 401k loan should be considered as comparable to any other loan - based on its terms - if there are any loan fees, is the interest rate comparable and fair, etc.
The 401k loan means you are essentially locking a portion of your 401k plan to be earning a set interest rate - that you are paying back. But if you took the same loan from your HELOC you’d still be paying that amount with after tax dollars. If you took a PLUS loan from a bank, you’d still pay it back with after tax dollars. Why do I frequently hear people expect that loan repayments should be pre-tax as well.
If your liquid assets are low and you need to take a loan, you are not alone. Once you are in a position that you need a loan, then you should be comparing the options available at the time…
I like the suggestion that @6same7 made in post #15 - and OP may find that some combination of both 401k loans and HELOC withdrawals will be best - depending on the terms.
It looks like you have thought this all out carefully with the numbers. Yes, it can work. As others have said, and you well know, you do have to pay back the HELOC and the interest is no longer tax deductible. It may be useful to check up refinancing your house with a cash out mortgage. Do check carefully on what the interest, tax deduction, monthly payment issues are with such a move vs a HELOC. The tax implications of these things are complicated but if you find someone who can wade through them, it may be beneficial.
Look at the various loan options–the Direct loans that the kids can take each year starting with $5500 freshman year, and what the PLUS loans for parents have in the way of interest rates.
Nothing wrong with loans or dipping into 401K and other plans as long as you know the ramifications of doing so.
@twoinanddone, we pay interest only on our HELOC. Thank goodness.
Are you basing this plan on just the FAFSA EFC?
A school that meets need will base aid on the CSS profile and that most likely will look at your home equity as well.
If the second child attends a public OOS school, don’t expect them to give (more) aid when there are two in college.
@mommdc No, not basing on the FAFSA EFC, rather I meant that she had grant award offers that were in line with the FAFSA number. Most are still pending so there could be extra good news coming. We are hoping that our son gets similar offers in 2 years. We will have a better idea by May 1 when the ink is dry.
@cptofthehouse Yes the direct loans will probably be part of the strategy as long as the interest is less than what we can get with a HELOC. In this case the need from HELOC should be much less. We might still repay from our 401k.
@mommdc You said “A school that meets need will base aid on the CSS profile and that most likely will look at your home equity as well.” Good point. We tried to be very strategic in helping her choose schools to apply that included “meets full need” and that don’t consider home equity. Obviously this is a pretty short, competitive list. Most of these schools haven’t released their admission decisions yet.
Have you taken a look at borrowing from a whole life insurance policy (if you have?)