Can I borrow from my 401(k) to pay for my children's education?

Technically, yes. Nearly 83% of employer-sponsored 401(k) plans allow loans for whatever reason, according to the Profit Sharing/401(k) Council of America (PSCA). But should you do this? Absolutely not. There are far better ways to fund an education that don't require crippling your retirement stash.

First, let's talk loan basics. Generally, 401k loans are limited to half of the account balance or $50,000, whichever figure is lower. And the deadline to pay it back — with required interest that you pay to yourself — is five years. The loan rate is typically the prime rate (which currently stands at 4%) plus 1%. It's possible that your company has different terms, but most do follow these IRS guidelines.

Since you're borrowing from yourself, taking a loan can seem like a pretty harmless thing to do. But there are serious risks. For starters, if you leave your company for any reason, that loan could be called in — pronto. And if you don't have the cash on hand to repay it, your loan will be treated as an early withdrawal, which means you'll owe income taxes on the outstanding balance plus a 10% IRS penalty. This could easily lop 40% off your loan. Not pretty.

Even if you stick with your company, there's always the risk that you won't be able to pay off your loan within the five-year requirement. (After all, money must be tight, otherwise you probably wouldn't take out the loan in the first place.) "A lot of people take money out of their 401(k)s and never put it back," says Ellen Fairbanks, a Certified Financial Planner (CFP) with MDNA Financial Management Company in Pittsburg. "And that's just a very expensive way to fund anything."

And even if you do pay off the loan properly, you will also suffer in other ways. Most notably, all that money that was withdrawn has missed out on the magic of compounding interest. Just think: Folks who had 401k loans this year missed out on this year's gains. And keep in mind that while you can always get loans for college costs, "there's no way to get a loan for your retirement," says CFP Barbara Steinmetz of Steinmetz Financial Planning in Burlingame, Calif.

Now let's discuss some better options. Assuming you're talking about funding a college education rather than private high school or grade school, a better bet would be to have your kids apply for financial aid. Even if they don't get much in federal grants (which is money that doesn't need to be repaid), they will most likely qualify for a variety of student loans that will cover the bills. The good news? Right now, interest rates on student loans are at record lows: just 2.82% for kids who graduated from college and consolidated their loans in 2003. Granted, that might not be the current rate when your kids start to attend college, but that interest rate is capped at 8.25%, and the interest payments are also a potential tax deduction. Also, there are hundreds of private scholarships available to college students.

Parents can also take out loans, called PLUS loans, which currently have an interest rate of just 4.22%. You also should be sure to take advantage of the tax credits available, such as the Hope Scholarship and Lifetime Learning Credits. And if you still have a couple of years ahead of you, we strongly suggest opening a 529 savings plan or a Coverdell Education Savings Account, which will allow your college fund to grow tax-free, provided withdrawals are used for qualified expenses. (For more on both of these college-savings options, click here.)

Finally, another option — although it wouldn't be our first choice — is to tap your home's equity. The current interest rate on a $30,000 home equity loan is 6.33%, according to Bankrate.com and a paltry 3.42% for a $30,000 home equity line of credit. And that's before the tax break on the interest, notes Steinmetz. It could be worth considering for parents stuck with bills for private school for younger children, or those whose high income will prevent them from getting much in college aid.

For more on 401(k) planning, see our Retirement section.

Originally published on November 26, 2003.