College is Expensive: Are TSP Withdrawals an Option?

Education is one of the most significant investments you can make in your children, grandchildren, or other loved ones' futures. For federal employees, college planning typically ranks just under retirement planning for “most pressing financial goal”. But the tools designed to save for education are different from those designed to save for retirement, which leaves many of us asking questions:

• What is the best account for education savings?
• Does using a specific education savings account impact financial aid?
• What if my child ends up not needing the funds? Will I be penalized?
• Does the TSP allow for penalty-free education withdrawals like some other retirement plans?

Using the TSP for Education Expenses

The Thrift Savings Plan (TSP) is a powerful retirement savings vehicle for federal employees, but it is not specifically designed for education expenses. In fact, the only provision within the TSP that allows for early, penalty-free withdrawals is the “Hardship Withdrawal” provision.

Unfortunately, these are generally limited to severe financial needs, such as preventing eviction or foreclosure. Education expenses do not typically qualify as a hardship reason under TSP rules.

Loan Option: Federal employees can take out a loan from their TSP account, which can be used for any purpose, including education expenses. However, this should be approached with caution as it involves repaying the loan with interest and can impact your retirement savings.

Early Withdrawals: Withdrawals before age 59½ are subject to income tax and a 10% early withdrawal penalty. Because of this, there are very few scenarios where taking an early withdrawal would be a suitable option for education funds.

Given these limitations, it’s generally advisable to explore other dedicated education savings strategies.

Popular Strategies for Saving for Education

529 Plans

A 529 plan is a tax-advantaged savings plan designed specifically for education expenses. There are two main types:

1. College Savings Plans: These are investment accounts that grow tax-free when used for qualified education expenses, including tuition, fees, books, and sometimes room and board. These are the most common type of 529 plan and are what we’ll be expanding on below.
2. Prepaid Tuition Plans: These allow you to prepay future tuition at today’s rates, which can be beneficial if tuition costs rise significantly over time. These plans can be nice if you know exactly which school the beneficiary will attend but can be limiting if not.

Pros:

• Tax Advantages: Contributions to 529 plans grow tax-free, and withdrawals for qualified education expenses are also tax-free.
• High Contribution Limits: 529 plans generally have high contribution limits ($18,000 per beneficiary, per donor in 2024), allowing significant amounts to be saved.
• Flexibility: Funds can be used at most accredited colleges and universities in the U.S. and some abroad.
• Transferability: 529 accounts can be freely transferred between family members with no penalties or taxes.

Cons:

• Market Risk: Investment returns are subject to market performance, which can be volatile.
• Penalties for Non-Qualified Withdrawals: If funds are not used for qualified education expenses, earnings are subject to income tax and a 10% penalty.
  • Note: There are a few exceptions to this rule.
    • Any amount of scholarship received by the beneficiary can be withdrawn from the account penalty-free.
    • Recently, the SECURE Act 2.0 introduced the ability to roll up to $35k from a 529 plan into a Roth IRA for the beneficiary as long as certain criteria are met.

Impact on Financial Aid:

• Parental Assets: If the 529 plan is owned by the parent, it is considered a parental asset and is assessed at a lower rate in the financial aid formula (up to 5.64%).
• Grandparent-Owned Plans: These do not affect financial aid until funds are withdrawn. Once withdrawn, they count as student income, which can reduce aid eligibility.

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) Accounts

These custodial accounts allow you to transfer assets to a minor. The funds can be used for any purpose that benefits the child, including education expenses. While these accounts do not offer the same tax advantages as 529 plans, they provide more flexibility in how the funds are used.

Pros:

• Flexibility: While the child is a minor, the funds can be used for anything that benefits them, excluding things that would be reasonably expected of a parent to provide (housing, food, basic necessities). Once the child reaches the age of majority, the funds can be used for anything.
• Control: The custodian manages the account until the minor reaches the age of majority.

Cons:

• Taxation: Earnings are taxed at the child’s tax rate, which is usually lower than the parents' but does not offer tax-free growth like a 529 plan. In addition, it’s important to be aware of “kiddie tax” rules that are meant to stop people from abusing these types of accounts.
• Ownership Transfer: When the minor reaches the age of majority, they gain full control over the account and can use the funds for any purpose.
• Inflexibility: Unlike 529 plans, UTMA/UGMA assets cannot be transferred between family members or withdrawn by the depositor. Once funds are deposited into the account, they must be used for the benefit of that child.

Impact on Financial Aid:

• Student Assets: UGMA/UTMA accounts are considered assets of the student and are assessed at a higher rate (20%) in the financial aid formula, which can significantly reduce aid eligibility.

Roth IRA

A Roth IRA, while primarily a retirement account, can also be used for education expenses. Contributions can be withdrawn at any time without penalty, and earnings can be withdrawn tax-free for qualified education expenses, provided certain conditions are met. This can be a useful dual-purpose savings strategy, and one that is often overlooked.

Pros:

• Tax Advantages: Contributions grow tax-free, and qualified withdrawals are also tax-free.
• Flexibility: Funds can be used for retirement if not needed for education.

Cons:

• Contribution Limits: Annual contribution limits apply ($7,000 for those under 50, $8,000 for those 50 and older in 2024).
• Income Limits: Eligibility to contribute phases out at higher income levels.

Impact on Financial Aid:

• Parental Assets: Roth IRAs are not considered in the financial aid formula, but withdrawals can be counted as income, which can affect aid eligibility.

Conclusion

For federal employees, planning for education expenses involves understanding the limitations of the TSP and leveraging other savings vehicles like 529 plans, Coverdell ESAs, UGMA/UTMA accounts, and even Roth IRAs. Each option has its own set of benefits and considerations, and the best choice will depend on your specific circumstances and goals.

Starting early, contributing regularly, and taking advantage of tax-advantaged accounts can help ensure that you can provide significant financial support for your loved ones' educational journeys.

Additionally, understanding the impact of each savings vehicle on financial aid is crucial for optimizing your strategy. By carefully considering these factors and planning ahead, you can effectively manage education expenses and secure a brighter future for the next generation.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.

 A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.