The following is an anonymous question submitted to Your Money Line and was answered by one of our highly-trained Financial Concierges. All identifying information has been removed.

“I’m trying to save for graduate school, and am wondering if my current strategy makes sense. I’m maxing out my 401(k) with the idea that I can withdraw from it without penalties if it’s to pay for education. Am I going about this right?”

Dear “Am I going about this right?”,

Well, no, not entirely. You’re doing a lot of things right. Let’s start there. Saving for your graduate school, saving for retirement, maxing out your 401(k); those are all great things to be doing. Unfortunately, the investment vehicle used to achieve your graduate school goal is not one of those great things. Never fear, I have some ideas.

You see, if you take funds out of your employer-sponsored 401(k) you do in fact pay a 10% early withdrawal penalty and you’ll be subject to income tax as well. Let me break this down.

If you take, let’s say, $10,000 from the account each semester. (I’m not sure of your tuition expectation or other scholarships, so we will just work with round/generic numbers.) By removing these funds from their tax-deferred account you are increasing your taxable income by $20,000 per year. In addition to paying taxes at your current tax rate, you will be subject to an IRS penalty of 10%.

Let’s say you pay taxes at a 22% rate. You will pay $4,400 in taxes and $2,000 in a penalty. Your $20,000 withdrawal suddenly became $13,600 to be used for higher education. In addition, an employer-sponsored 401(k) is not likely to offer a wide variety of investment choices. It is important to make sure the funds you will need for education are invested appropriately. Are you looking to use the funds in the next 5 years or less? If so, these funds should be conservatively invested, unlike the other funds in the account which are truly being saved for retirement.

Is there a better way?

Yes, there is, I’m so glad you asked.

There are a few options for funding your future higher education expenses that won’t cost you the penalty. You mentioned in your question that you are “maxing out” your 401(k) contributions. You could take the funds you deem allocated for “future higher education” and fund a separate IRA. This account could be a Traditional or Roth. If you need to withdraw funds for grad school expenses you will not be assessed the 10% penalty. If you don’t need the funds you are able to continue to contribute to the account with perhaps more investment flexibility. In addition to an IRA, you could invest in a 529. Or, if your need is in the immediate future, keep these funds in a high yield savings account. I do think it would be wise to speak with a tax advisor on which route will behoove you.

The bottom line? There are many ways to be saving for education expenses. The goal is to make sure you’re saving for these expenses in a way most advantageous for you.

Sincerely,

The Your Money Line Financial Concierge Team

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