Should you tap your retirement funds to help pay your child's college expenses? Well, you can. But is it a good idea?

The double problem with double dipping

Financial professionals generally recommend using your retirement funds for one purpose only--retirement. Why? Because frequent dips into your retirement funds will reduce your ultimate nest egg. Plus, there will be less money available to take advantage of the twin benefits of tax deferral and any compounding earnings. Depleting your retirement funds too soon can create a dire situation. Remember, there is financial aid available to help pay for college, but none for retirement.

But if you must ...

If you absolutely must dip into your IRA to pay college costs, there is a bit of good news. Generally, if you withdraw money from a Roth or traditional IRA before age 59½, you'll owe a 10% premature distribution penalty tax on the earnings portion of the withdrawal. However, there is an exception to this penalty if the money is used to pay the qualified education expenses for you, your spouse, your children, or your grandchildren. That's the good news.

The bad news is that you'll owe income tax on the earnings portion of your IRA withdrawal. But fortunately, for Roth IRAs, there is a tax ordering for distributions--contributions come out before earnings. This is important because contributions to a Roth IRA are made with after-tax dollars and can be withdrawn income tax free at any time (even before age 59½) and for any purpose. You'll only owe income tax if you dip into the earnings. (Once you reach age 59½ and have held your Roth IRA for five years, even earnings are income tax free.)

What about your 401(k)?

Generally, tapping your 401(k) is even worse than tapping your IRA, because 401(k) plans don't offer a college exception to the 10% penalty tax. Plus, you'll generally pay income tax on the entire amount of your withdrawal. So all other things being equal, withdrawing from your IRA is the better choice.

However, you might be able to borrow from your 401(k) account--something you can't do with an IRA. Assuming your plan allows plan loans, loans are not taxed or penalized, as long as you repay the funds within a specified period of time. But make sure to compare the cost of borrowing from your 401(k) account with other financing options. Although interest rates on plan loans may be favorable, the amount you can borrow is limited, and you generally must repay the loan within five years (some plans require that you repay the loan immediately if you lose your job).

The financial aid factor

Assets in retirement accounts aren't counted at all by the federal government's financial aid formula. So they don't affect your child's eligibility for federal financial aid. However, distributions are counted; specifically, all withdrawals from retirement accounts--principal and earnings--are counted as parental income and assessed at rates as high as 50%.

Alternatives

Before you dip into your IRA or 401(k) account to pay college expenses, make sure to investigate the cost of private borrowing, as well as any federal, state, or college-based financial aid loan programs that might be available. For example, under the federal PLUS loan program, you can borrow up to the full cost of your child's education (minus any financial aid received) if you have a good credit history. Similarly, your state's higher education authority might have a financing arm that offers favorable loan terms for college.