What to Consider Before Selling Investments to Pay for School

Dipping into an investment account to pay for educational expenses can allow you or a loved one to minimize the need for student loan debt. If you created the investment account specifically for that purpose, you may not think twice about the decision.

But before you sell off investments that weren’t originally designed to cover college costs, it’s important to consider the potential downsides, including the tax implications and opportunity costs.

Potential Tax Implications

The way investment gains are taxed can vary depending on the type of account you have and how long you’ve held the investment you’re selling:

• 529 plan or Coverdell ESA: Withdrawals are tax-free as long as they’re used for qualified educational expenses.
• Brokerage account: Gains are taxed at your ordinary income tax rate on your gain if you’ve held the investment for less than a year. If you’ve held it for longer, you’ll pay a lower long-term capital gains tax rate.
• Custodial account: The first $1,250 in gains are exempt from income tax; the next $1,250 in gains are taxed at the child’s income tax rate; all additional gains are taxed at the parents’ income tax rate.
• Traditional 401(k) or individual retirement account: You’ll pay your ordinary income tax rate on both your gain and the original contribution, and you may also be subject to a 10% early withdrawal penalty.
• Roth 401(k) or IRA: Roth accounts allow you to withdraw up to your contribution amount with no tax consequences, but if you dip into your gains, you’ll pay your ordinary income tax rate and may be subject to a 10% penalty.

Depending on the type of investment account you have and how much you withdraw, you could be on the hook for a sizable tax bill. Consider consulting with a tax professional to understand what to expect.

Lost Investment Gains

Again, if you originally set up the investment account to pay for college expenses, this may not be an issue. But if the investment account has another goal, you’ll want to consider the opportunity cost of withdrawing money instead of leaving the funds alone.

The average annual return in the stock market is roughly 6% to 7% when accounting for inflation. In contrast, undergraduate college students can get federal student loans with a 5.5% interest rate for the 2023-24 academic year.

In other words, the cost of student loans may be lower in the long run than what you could gain by leaving your investments in the market. What’s more, you or your child may be eligible for student loan forgiveness or repayment assistance, both of which further reduce the cost of student loan debt.

Limited Future Financial Options

Dipping into an investment account that’s earmarked for future needs, such as retirement, can significantly limit your options when you ultimately need those funds. Even if you feel like you’ll have enough time to catch up, you’re still taking a significant risk.

Alternative Ways to Fund Your Education

Before dipping into your investments, consider other options for covering educational expenses, including:

• Scholarships: Colleges and universities may offer scholarships to students on the basis of financial need or merit. Check with the school’s financial aid office to learn about available scholarships and how to qualify. You can also use scholarship databases like Scholarships.com and Fastweb to research and apply for private scholarships.
• Grants: You may be able to take advantage of federal and state grants simply by filling out the Free Application for Federal Student Aid (FAFSA). Additionally, scholarship databases can also include private grants.
• Employment: When you fill out the FAFSA, you may also be eligible for the federal work-study program, which can give you access to part-time jobs both on and off campus (though employment isn’t guaranteed). If you want more control over your work hours, you can also apply for jobs on your own.
• Student loans: Options include federal and private student loans, but it’s best to start with federal loans. Federal loans have standardized fixed interest rates and flexible repayment options, and they typically don’t require a credit check when you apply. In contrast, private loans may have varying fixed and variable interest rates that are based on your creditworthiness and less flexible repayment options. To apply for federal student loans, simply fill out the FAFSA each year. With private loans, you need to apply with each lender individually to compare rates.

How to Choose College Funding Options

With so many different ways to pay for college, take some time to research all of your options to determine the best approach. In most cases, students and parents may need to rely on multiple options.

For example, you may be able to use scholarships and grants to pay for some of your tuition and fees, work part time to pay for living expenses, sell off some investments to pay for books and supplies and use student loans to cover the rest.

Here are some steps to help determine the right mix for you:

1. Carefully consider your situation and the options that are available to you.
2. Take the necessary steps to apply for financial aid, so you have a better idea of what you’re working with.
3. Evaluate your expenses, including upfront and ongoing costs.
4. Determine how much you’ll need from each source to satisfy your educational expenses.
5. Be sure to reevaluate your situation each year, as some options, such as scholarships, grants and employment opportunities, can change over time.

The Bottom Line

If you’ve been investing for educational expenses, using those funds when the time comes may be a no-brainer. But if you’re thinking about selling off investments earmarked for other financial goals, carefully consider the potential advantages and disadvantages, along with other options, to determine whether it’s the right move.

At O1ne Mortgage, we understand the complexities of financial planning for education. If you need expert advice on managing your investments or exploring other funding options, don’t hesitate to call us at 213-732-3074. Our team of experienced loan professionals is here to help you make the best financial decisions for your future.