Many people wonder if tapping a 401(k) plan is a good way to help pay for an MBA. The considerations are similar for those in 403(b) and 457 plans as well. There are two options:
- Withdraw from the 401(k)
- Take a loan from the 401(k)
Withdrawing From a 401(k)
The IRS allows taxpayers to withdraw from 401(k) and other retirement accounts without the 10% penalty for early withdrawal if the money is used to pay for education expenses. It is also necessary to have an immediate financial need to pay for education expenses. In other words, the early withdrawal penalties still apply if the taxpayer had other sources of money to pay for educational expenses. Most students will not have any problems getting the penalty waived.
The biggest problem with withdrawing is the big tax bill. When tuition bills from an expensive MBA program are looming, paying a big IRS tax bill may be difficult. And those who are in states with an income tax will have to pay even more. Many end up paying more than 1/3 of the money withdrawn from the 401(k) to pay for taxes. It is probably a good idea to have the part of the withdrawn money withheld for taxes.
Another issue with withdrawing from a 401(k) plan is the inability to put the money back in. Once the contribution is withdrawn, it can’t be put back in. And the withdrawn funds cannot participate in the 401(k) account’s future gains (and losses). Over the long run, students may be giving up a big chunk of their retirement in order to use the money to pay for an MBA. On the other hand, many students make a lot more money after graduating, so it can be worthwhile to withdraw in certain instances. However, anyone who is thinking about withdrawing should seriously consider a 401(k) loan instead.
Borrowing from a 401(k) Loan
Another option to consider is to borrow from a 401(k) account. Under current IRS rules, it may be possible to borrow up to the lesser of 50% of the account value or $50,000. The maximum repayment period is 60 months (5 years). Students will need to be able to make monthly payments while the loan is outstanding. This is a possible solution for those who plan to continue working while pursuing the MBA.
You’ll need to make monthly 401(k) loan payments while studying or it will become an early withdrawal with taxes due. Since you’re using the money for educational purposes, you should be able to avoid the 10% early withdrawal penalty.
Many people, including some financial professionals, believe that it is a bad idea to take out a 401(k) loan since the money has to be repaid with after-tax funds. Then the 401(k) money is taxed again. As a result, many financial planners claim is made that a 401(k) loan results in double taxation. Nothing could be further from the truth. Here is why:
- The proceeds from the 401(k) loan are tax-free.
- You are repaying the interest to yourself. It does not go to a bank.
- No need to withhold any money for taxes since you’re repaying the loan.
- You are repaying disbursed funds which were never taxed. The only funds that are subject to double taxation is the interest, which is minimal. (You were taxed on your salary and will be taxed again when withdrawing the interest from the 401(k) )
- Aside from the double taxation on the small amount of interest, there may be loan fees incurred.
- You will not be able to participate in the gains (and losses) in your retirement account.
For most students who plan to continue working, it may make sense to borrow from a 401(k), 457, or 403(b) plan. Contact your employer to find out if it is possible to borrow from your employer’s plan.
Financial Aid Considerations of Using 401(k) Money for an MBA
Those who are getting need-based financial aid may need to worry if they are dipping into retirement accounts to fund the MBA. First of all, any loan disbursement funds that have not been spent will count against the student for financial aid purposes. Secondly, those who withdraw from a 401(k) or other retirement account will have taxable income that will count against financial aid.
Those who are getting 401(k) loans do not have to worry about extra income ending up on the FAFSA. But they should still spend down any disbursed funds prior to filling out the financial aid application.
Contributing to a 401(k) Before Going for an MBA
Many workers know that they are going to work for a few years prior to returning to school to get an MBA degree. Work experience can be very helpful in gaining admittance to a top tier program. So one decision to make is whether or not to continue contributing to a 401(k) plan.
If your 401(k) balance is $100,000 or less, you can often borrow half of it when you go to school. Find out if your employer will let you do so.
Over a lifetime, there is a limited amount of money that can be put into a 401(k) plan. If you don’t put it in for a particular year, you generally lose the chance to ever put it in. Once your 401(k) is above $100,000, the rest of the money is trapped unless withdrawn early or retired. You can’t borrow more than $50k. So put in the max to the 401(k) until the balance is $100k.
After that, you may want to put the remaining funds in a Roth IRA (or backdoor Roth IRA if above the income limit). The contributions can always be withdrawn without penalty and without taxation. Earnings are subject to the penalty, but not if they’re used for educational purposes. Earnings are subject to tax if withdrawn prior to turning age 59 1/2.
If there are any additional savings, consider putting it in a 529 plan if there is a state income deduction. If there is no state income tax deduction for establishing a 529 plan, the only reason to use it is to prevent the earnings from being taxed until the funds are withdrawn. Many people find that 529 plans are not worthwhile, but that varies from person to person and from state to state. Here is more information about the 529 plan.
Here is more information on dipping into your retirement account to pay for an MBA.
Those who don’t want to touch their retirement savings may want to consider using a HELOC to pay for the MBA.