Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.
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?
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 a high-interest loan 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!
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.
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.