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One of the most popular things we do on this blog are Reader Cases, and while they are (I won’t lie) a TON of work for us, they never cease to surprise us in the comments they generate, because we invariably learn something from people who were in a similar situation or have something interesting to add. Here’s last Friday’s Reader Case. In it, our intrepid reader had pulled out of poverty by getting into college, amassing 5 degrees, and securing a 6-figure job. But in doing so, she also amassed a six-figure student debt, and had emailed us to ask what the Hell she was supposed to do with it.
So we ran a bunch of scenarios and did a bunch of projections and concluded she should a) continue paying the minimum in the hopes that the Public Sector Loan Forgiveness program would kick in while simultaneously b) look for a more lucrative job in the private sector that would allow her to kill that loan with cold hard cash, Loan Forgiveness or no Loan Forgiveness.
And in our projections, we used an Illinois tax calculator to determine her after-tax income, baking in the assumption that she would max out her 401(k) (well, 403b since she worked in a university).
Two things happened:
- An eagle-eyed commenter noticed “Hey, if she works in a university she might be eligible for a 457 as well!” This is the retirement program available to state and local government employees, and it’s possible to be eligible for a 403(b) AND a 457 at the same time, allowing someone to potentially tax-shelter $36k of income. Over email, we asked her if this applied to her and lo and behold, she discovered that YES, it did! So thank you reader “Frank” for your observation! You just saved our reader a butt-load of money!
- Another commenter asked “Wait, if she’s putting all this money into her 401(k) (and equivalents), how is she going to use that money to pay off her debt?”
The second question is the topic of today’s article.
First of all, to our Canadian readers I will use our national greeting and apologize to you. This will be a very American-focused article. What we’re about to talk about applies mostly to our American friends and not to you guys. But at the end, I will explain why this is a very VERY good thing for us. But for now, I have to address the Americans. Sorry.
USA! USA! USA!
Alright, now that there are just Americans around, who’s jacked about your MASSIVE STUDENT DEBT PROBLEMS?
*crickets*
OK maybe that wasn’t the best intro, but let’s not dwell on who intro’d what, and get back to the task at hand.
How do we pay off your student debt with a large 401(k) balance?
Just to recap: A 401(k) (or a 403(b) or a 457 or a TSP) is a tax-deferred account. You contribute pre-tax money to it, and it decreases your taxable income by the amount of your contribution. This reduces the taxes you owe to the government, and the amount in your 401(k) compounds tax-free until you withdraw when you’re retired, at which point it gets treated as regular income. Here’s a guide on how to perform this withdrawal tax-free.
But here’s the problem: If you haven’t retired, and you aren’t age 59 1/2, any withdrawals from your 401(k) are taxed at your marginal tax rate, plus a 10% penalty! So what can we do?
Simple: Take a loan out on your 401(k).
Now, before I get into the nitty gritty, let me just say that while the government allows this, it’s up to each 401(k) plan administrator to offer it as an option, so check with your payroll department to see if this is allowed.
But if it is, you can basically write a loan to yourself from your 401(k). This allows you to access up to 50% of your vested balance, or $50k, whichever is less, tax-free! You are then required to pay that loan back (again, to yourself) within 5 years (though check with your plan administrator for the details).
Now a word of caution here: If you were to look this up in Google, you would find pages and pages of financial advisors screaming DO NOT DO THIS, THIS IS A BAD IDEA. And they aren’t wrong. Because if you take out a loan on your 401(k) and use it to just buy shit, then you just done fucked up your retirement plan. That’s bad.
BUT, if you are doing this to pay off high-interest student debt like the one from our Reader Case, then it actually does makes sense. Why?
Because you are essentially replacing a loan where interest is due to the government with a loan where interest is due to yourself.
You have to pay interest. This is a loan, so no wiggling out of it there. But if your loan is to your own 401(k), you’re not actually losing money to interest anymore. You’re just transferring it from one bucket (owned by you) to another bucket (owned by you).
A 401(k) loan actually does something interesting to…uh…interest. Instead of a low interest rate being beneficial to you, since you’re paying less per month to a bank, when the loan is to yourself, a HIGHER interest rate is actually more beneficial to you, since it allows you to shovel more money into your 401(k). More money in your 401(k) means more of it to will compound tax-free.
Now here goes my caveat: Check with your payroll/HR department to see if this is a feature your 401(k) plan allows. And there are a TON of stars-and-asterisks. For example, if you lose your job and are unable to make a payment to your own loan, you will be considered in default and the unpaid balance will become fully taxable at your marginal rate. This is bad.
But with the stars-and-asterisks in mind, borrowing from your 401(k) SPECIFICALLY to pay off a high-interest student loan can be a way to convert a loan in which you pay interest to the government into a loan in which you pay interest to yourself!
Oh, Canada!
And don’t worry, I haven’t forgotten about you, Canada! But unfortunately, I have bad news and good news.
Bad news: There is no equivalent scheme to access our RRSPs for us Canucks.
Good news: We don’t need it as much.
One of the biggest problems our American readers have is the ol’ student debt switcheroo. You get a high-priced degree, you realize that degree is worthless, then you’re stuck with $100k+ of non-dischargable debt with no good job to pay it off. We should count ourselves lucky, because we have programs that make our debt go away if it turns out those degrees turn out to be useless.
Our RRSPs (the equivalent of 401(k)’s) also don’t have the early-withdrawal-penalties that our American friends have. We can take it out anytime we want (though it DOES get taxed at our marginal, but without that annoying 10% penalty fee).
There are only a few ways for Canadians to withdraw money from our RRSPs tax-free:
- The Home Buyers Plan. We can withdraw up to $25k from our RRSPs to fund a first-time house purchase. The withdrawal must be paid back over 15 years.
- The Life Long Learning Plan. We can withdraw up to $10k per year to fund full-time tuition. The withdrawal must be paid back over 10 years.
- An RRSP Mortgage. If you have a large loan balance, you can use it to fund your purchase of a house. This is similar to the 401(k) loan in that it allows you to convert a loan to the bank into a loan for yourself, but since mortgage rates are so low these days it makes no sense to do this. You can earn way more inside your RRSP than in covering your 2.5% loan.
So there you have it. 401(k) loans: Great if you have a big-ass student debt, bad for everything else. And for Canadians, just your RRSPs the way they were meant to be used – for retirement.
Wanderer Out.
Continue onto the next article!
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One more tip for MAS and other American readers at non-profits. You might have a *third* tax advantaged account option! Some non-profits or public sector employees have access to 403(b), 457, AND 401(a) plans.
At my institution, the 401(a) works like a 401(k) and comes with a match. I was also auto-enrolled, nice since I was clueless & thinking about other things when I started. The 403(b) and 457 plans were opt-in and had no match, but still have tax advantages. It took my wife and I a while to figure out the 403(b) and 457 plans and set them up, but fortunately there were some nice options like Vanguard index and target date funds and we kicked them into gear in mid-2009. I made some other mistakes, so I wasn’t able to max out the contributions every year. It’s still an incredible way to stash a lot of cash into retirement accounts, they’re getting up there after 10 years of relatively steady investing.
Yes! Thanks for this advice. I actually contribute to the 403b and the 401a and thought the combined total was $18,000. Didn’t realize they weren’t aggregated and the $18,000 limit applies to the 403b alone. Called intuit just to be sure. So, it seems I have quite a few options to save for retirement 403b, 401a, and 457b. Now to cut my expenses OR earn extra income so that I can make it happen. Now there’s the rub.
Ironically, I did the same thing at my university and I have the same thing. I have a 401(a) automatically enrolled. And I thought I could contribute only a combined 18k. I was wrong and this last year is the first time I am fully funding my 403b…I wish I could do more with the 457. Good luck on paying back the loans. This is one time when I can say I know what you are experiencing.
Good Lord, there’s ANOTHER retirement plan, so what is that, $54k you could shelter in total? That’s crazy!
I know, right? I’ve been working these plans for several years, though only able to hit the max in all four retirement accounts (Roth IRA, 401a, 403b, & 457) a few times.
Could I interest you in a reader case study?
Well, it could be $54,000 it could be more. The 401a at my institution is 5% of my base salary. So, that makes a total of $40,100 for me. I checked out my previous institution and some others and I saw 4.5% of total salary, 6% of salary, and one institution allows for 8%, but only for employees making $118,000 or more.
That’s a lot of contribution room … okay, I’m changing my advice. Slam every dime you save against the student debt, except for 6 months of emergency funds. Why? To free up your income as quickly as possible so that you can begin to max out those contributions as early as possible.
Time is your ally. The sooner you begin to max those contributions, the more time you have to work its magic on multiplying the amounts in the plans.
I just want to make sure I have the math right on whether this is a good idea or not:
First you have your existing student loan(s). You’re paying some overall percentage on that debt.
Second, you have the loan your servicer will give you from the 401k. Your “return” on that is the interest rate your servicer is willing to give you.
Finally, you have the opportunity cost of pulling money out of your 401k. Generally assumed 7% return here, assuming you’re in low cost index funds.
So as a worked example:
Student loan of $10,000 @ 6.25%
401k loan of $10,000 @ 4%
Opportunity Cost of pulling $10,000 out of 401k @ 7%
Loss, gap between opportunity cost and 401k loan “return”: $10,000 @ 3%.
Savings on debt servicing of student loan: $10,000 @ 6.25%.
Net benefit: $10,000 @ 3.25%
Yes?
Not quite. The 4% interest you pay yourself doesn’t act as interest in the traditional sense since it’s not money that leaves your accounts, just money that gets shuffled from one account to another.
In your scenario, you have an opportunity cost of $10k @ 7% vs debt savings of $10k @ 6.25%, so you’re actually slightly down by $10k @ 0.75%. Of course, the debt interest is fixed while the ROI on your investment is highly variable, so this may still make sense to do. And if the student loan interest is only slightly higher, it definitely makes sense.
Thanks for not forgetting Canadians 🙂 I am addicted so to your blog that cannot wait for your weekly updates..
I finally pulled the trigger and opened quest trade account using your link. I am gearing up for my first buy on June 1st..mean while I am still trying to figure out should I use my RRSP full room or not (no brainer if I contribute pretax amount) but being self employed and I take minimum wages to myself and my wife..never get to really use the RRSP to save taxes..
Now the lump sum tax paid amount should be funded into RRSP and then get my principle tax paid amount also subjected tax at the time of withdraw or not..
due to this I opened only Non-Registered account (TFSA is already full) but still researching to start with RRSP or Non-Registered account?
I sent an email hope it did not get lost in your inbox…
Wish any of you can clarify my dilemma so that I can confidently do my first buy next week.
I’m not really sure what you are asking but have you checked out the other two blog posts they’ve done about how to minimize your taxes? https://www.millennial-revolution.com/invest/workshop-invest/making-investments-tax-free/ and https://www.millennial-revolution.com/invest/let-government-fund-retirement/ ? This will help you decide which assets to buy with your RRSP account. You might not want to use the full room of your RRSP depending on your income especially if you are making minimum wage. You would want to figure out how much you are making pre tax and then figure out how much your contributions will benefit weighing in factors like how big your tax return would be, how much you need to contribute to bring your taxable earnings down to qualify for GST/HST credits or cheaper MSP premiums (I think that’s a BC issue only). It also depends on what you are saving the money for, remember that you will get taxed on anything you withdraw that is over $20k between the 2 of you when added to your combined yearly income. I’d assume most people here are investing for retirement and therefore that might not be an issue but if you are just here for investment advice in general and not necessarily for retirement then that might be something to consider. Hopefully this helps I don’t know a lot about this stuff but i’m sure someone else will correct me if anything I said was incorrect
Yeah our inbox is a fireball of disaster, I’m like a WEEK behind in replying to everyone.
Anyway, when you contribute into your RRSP, you will generate an RRSP deduction which will reduce your current year’s taxable income. Typically this will generate a tax refund from the government. You are correct that when you withdraw you will be taxed on your withdrawals, but if you carefully time your withdrawals post-retirement like we describe here (https://www.millennial-revolution.com/invest/workshop-invest/making-investments-tax-free/), you can do it tax-free.
But above all else, CONSULT WITH YOUR ACCOUNTANT before you do anything with your RRSPs. You mentioned in a previous email that your accountant was doing fancy things to reduce your taxes inside your business, so you’ll want to coordinate your investment strategy with them. You don’t want to accidentally do something that screws up whatever they’re doing on the corporation side.
Thanks guys,
I will contact my account this weekend before loading up RRSP account with my tax paid amount.
I wonder how many students from useless schools like CDI and Art Institute end up on RAP. For almost a decade I worked a manual labour job with no post secondary requirements (I actually knew of a lot of people there who didn’t even graduate from highschool) and I knew quite a few people who’d went to AI or other private art schools and couldn’t get a job but had huge student loans to pay off and a handful that had went to a place like CDI for something completely unrelated to what they were doing. I have only met 2 people who have went to AI who have went on to succeed in the industry after graduation.
Neat trick! I hadn’t thought of that use for a 401k.
Everyone has an “opportunity cost” cut off where it no longer makes sense to pay off debt with money that could be used to invest (or, in this case, is already invested). For me, it’s about 7% (if my interest is higher than that, I’ll probably pay it down first, otherwise I think investing is a better use of the funds). But it’s kind of a personal decision. For some bloggers, anything higher than 4% (including a mortgage) is something they’d rather pay down rather than invest.
Yeah, it’s more of an emotional decision than a numbers one at that point. I hate debt too, I’d probably pay it off even if it made financial sense to keep it around. That’s why I don’t invest using debt even now.
Just a word about the interest rate on a 401k loan. I could VERY well be wrong, but the interest doesn’t go to you. It goes to the plan administrator. So if you borrow $50,000 at a, say, 3% rate, you will only have the $50,000 returned when you pay back the loan. The plan administrator pockets the rest.
It’s something I would make sure of before taking out any 401k loans. Though some student loans have rates so high that it STILL makes sense to do something like this, it’s something that you don’t want to miscalculate. You don’t want to think you’ll end up with more in your retirement account than you really will have.
I wrote a similar article recently called “Should You Use A HELOC To Pay Your Student Loans?” and my conclusion was a big fat “It depends”. But I wasn’t too sold on that idea because, while the difference in interest rates was usually enough to make the idea worth considering, you were now collateralizing your student loan debt. In my article, the idea was putting your house up as collateral. Here, the idea is putting your retirement itself up for collateral.
Generally speaking, I don’t care for the idea of loans from retirement accounts, annuities, whole life insurance policies, and the like. I sell fixed annuities and generally don’t even mention that feature to my customers (it’s in the brochures and contracts). To me, it’s more of a feature of last resort and not a selling point that I want to highlight and magnify, lest the customer borrow money they can’t pay back and jeopardize their income stream or get themselves into a tax burden they can’t reasonably handle.
Sincerely,
ARB–Angry Retail Banker
Nope, interest goes into your own 401k, not the plan administrator. From Investopedia:
Another confusing concept in these transactions is the term “interest.” Any interest charged on the outstanding loan balance is repaid by the participant into the participant’s own 401(k) account, so technically this also is a transfer from one pocket to another, not a borrowing cost or loss.
Source: http://www.investopedia.com/articles/retirement/08/borrow-from-401k-loan.asp#ixzz4i3n6m3WF
I wholeheartedly agree with your take that this shouldn’t be a decision someone takes lightly though. If someone raids this and then just spends the money they are screwing over their retirement, but if you have a giant 401k AND a giant pile of high-interest student debt like some of our readers do, it doesn’t make sense to just leave that debt there.
Actually, I don’t like this concept of investing money by bringing it on debt. It may some times favor but not all times. But your saying on this 401K debt is some way different which just expected to have trivial or minimum interest rates. So, need to give a try.
Smart, or not smart?
I’ve gotten myself into a little bit of an issue with cash flow, meaning we deplete our cash while saving around 20% of our income. The main contributors for being cash strapped are new college expenses (my wife is a teacher, and is getting her Masters) and daycare for our 16 month old. Importantly, these are both temporary expenses (although 4 years of day care is relatively long term).
I have $20k that would be a candidate for the method in the article, as they are previous student loans. However the payment would increase by $180 a month if I converted to a 401k loan, further depleting cash.
I’m considering using an IRA from a previous employer’s 401k to keep from taking on debt due to the new college expenses. Early withdrawals seem to be forgiven the extra 10% fee, if applied to college expenses within the calendar year. It may be that if I try to withdraw enough to cover the nominal tax too, that portion would be subject to the extra 10%, if I read the language correctly.
I could alternatively reduce my savings to create cashflow, but if I did I would fall below the percentages required to maximize company matches. Also, long-term, I’m planning to increase savings percentages based on annual raises due to my wife’s payscale. I think it’s more important to stay on curve with that plan than to hold 100% of my current retirement balances (our yearly contribution will double within 5 years if we stay on track).
I think I’ve found a way to put money into an IRA and let it grow tax-free, but still pay tuition bills at my normal tax rate. So, is it too good to be true? Am I not accounting properly for opportunity cost?
Correct. You can withdraw from your IRA to pay for college costs and that generally makes more sense than going into debt and then trying to dig out of it later (unless you can get a student loan for significantly lower rate than 7%)
It’s not a terribly common scenario, since most students don’t have an IRA when they start college, but in your case it’s definitely worth checking out. If you can withdraw from your wife’s IRA, that’s even better since you’ll be able to get it out tax free (assuming her earned income is 0).
She’s working while getting her master’s, so I think the tax is inevitable. No IRA for her either, she had a 403b with a small balance that we are rolling into her current 403b.
We are vetting all options for potentially low rates on loans, but no dice to this point. We have reduced our debt every year for a decade now, it’s really a streak we want to keep.
Thanks for the advice!! Been reading for a few months now (came over from JL Collins who I found via Mr. 1500). Really enjoy the content!!
Hmm. Jobs can go bye-bye quickly. I suspect it’d be wise to borrow only what you can repay in 6-12 months, rather than much more. That way, should your job disappear and call your 401k loan, you don’t suffer as big a hit.
For love of all things FINANCIAL! Please never take a loan out of your 401k, it is a complete scam on yourself. Here are the reasons why:
1. Once the money is out of your 401k it is no longer compounding toward your retirement. I know people who take out 401k loans every few years because they don’t want to pay the high interest rates on a personal loan. This sweeps the leg out of your retirement potential.
2. The money you place back into your 401k is POST-TAX, AHHHHHH, WTF! Yes it is true that the interest you pay on your 401k loan is placed back into your account and not the administrator/custodians pocket. But just think about the fact that you are likely in the 15% or higher tax bracket, I doubt your 401k loan will have that high of an interest rate.
3. Hey wait a minute, lets go ahead and pay some more tax just because… A lot of people think about this in the short term but fail to look at the long term. Guess what happens when you finally retire at 65 years old and you start cashing out your 401k. That’s right! You get to pay tax on your withdrawals and that loan you payed back with post-tax money is now being taxed a second time since it is in a 401k and not a Roth.
Here is the big picture: Your money stops working for you and then you pay twice the tax on those funds. I don’t know about you but I think I would rather just consolidate my debt into one low interest loan or start signing up for 0% interest credit cards that come with courtesy checks. Pay off the balance before the high interest kick in on the card and then cancel it.
Thanks for the article.