Borrowing from Your 401(k)

As the cost of college continues to rise, students have to borrow ever larger amounts of money to finance their education. In fact, according to Nellie Mae's 2002 National Student Loan Survey, the median loan debt for undergraduate students was $16,500. To help finance their children's education and avoid saddling them with crippling debts, some parents are taking out loans from their 401(k) plans. While that may seem appealing, it may in fact be better to have your child take out a student loan.

401(k) Loans Reduce Your 401(k) Earnings

If you borrow from your 401(k), you limit the potential growth of your retirement assets, which could be a problem since you only have a limited number of years to contribute to the plan. If you take out a loan for $10,000 from your 401(k), that amount won't be earning any money for you during the life of the loan. Had you not borrowed that money, you might have earned, for example, $1,000 from that $10,000. That $1,000 also would have grown over time, compounding each year. By the time you retire, that lost $1,000 of 401(k) earnings could have grown to be a substantial amount. However, in taking out that loan, you essentially robbed yourself of those additional earnings.

A Potential Shortfall at Retirement

The loss of these additional earnings in your 401(k) could potentially mean that you might not have enough funds when you retire. In that event, you might end up having to depend on your child to help make up the difference. This would place a heavy burden on your child, which is the very problem you were trying to avoid by taking out the 401(k) loan in the first place. The cost of your unfunded retirement may be beyond your child's budget, and if this implied obligation wasn't fully understood as part of the college-financing discussions, everyone could end up unhappy.

Pretax vs. After Tax

Another important point is that the contributions you made to your 401(k) were in pretax dollars. However, if you take out a loan, you'll be paying yourself back in after-tax dollars. In other words, once you take out that $10,000 loan, you'll need more than $10,000 in salary to pay it back (since taxes are withheld from your salary), which is a significant hidden cost.

Issues Related to Job Loss

Also be aware that some plans require an employee who loses his job to pay back the 401(k) loan immediately. If you can't repay the loan, then it will be considered income, and you must pay taxes on it. To make matters worse, if you are under 59 1/2, you will also have to pay a 10 percent early withdrawal penalty on the amount of the loan.

Your Child's Debt Burden

While it's difficult to see your child graduate with student loans, keep in mind that she has longer to pay off those loans, which gives her more flexibility. If you'd like to assist your child with debt burdens and your cash flow allows, you can always help make debt payments after graduation.