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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.
Every time an American reader writes into us with a Reader Case, our eyes bug out a little bit. Specifically, we bug out at your student debt numbers.
Americans, your student debt issues are INSANE.
Here in Canada, FIRECracker and I studied Computer Engineering at the University of Waterloo, which has a co-op program, so we paid our own way through University and we graduated with zero debt. But even if we didn’t, our total tuition for our 5 year program was around $40k, and when I briefly lost my mind and considered going to grad school, there were scholarships and grants like NSERC that would have covered it. So when Canadian readers write to us, their student debt numbers are usually in the $30k to $40k range.
But I REGULARLY get Americans writing into us with $100k, $200k worth of student debt. Hell, I personally have a relative that went to dental school in America and is currently sitting on a $500k student loan balance! And those are AMERICAN dollars, too!
So let’s spend today talking about a strategy that could help pay off your loans faster: Using your 401(k).
How Do You Do it?
So let’s say you’re working, you have a student loan you’re paying off, and you’re deciding whether you should put money towards making extra payments on your loan, or contributing to your company’s 401(k) plan.
If you pay down your loan, you pay less interest, which is good. But if you contribute to your 401(k), you get to participate in tax-free growth, as well as get any contribution matching your employer offers, which is also good. So what should you do?
Turns out, an option not many people know about is that many 401(k) plans allow you to loan money to yourself. It doesn’t generally require a credit check (since the lender is…you know…you), and the 401(k) plan administrator sets an interest rate on the loan which you have to pay back to yourself, generally 1% or 2% above prime.
You then take that money and pay off your student debt.
Now you’ve replaced your student loan with a loan to your own 401(k). In other words, you’ve replaced a loan to the government with a loan to yourself.
And here’s the weird part. Remember that interest rate the 401(k) plan set on the loan? You have to pay that as part of your 401(k) loan repayment. But since the interest is paid to yourself, no money has actually left your pocket. It just moved from one pocket to another.
In fact, in every other loan, a high interest rate is bad since you’re giving someone else more money. But in a 401(k) loan, a high interest rate is actually good, since it allows you to shovel more money into a tax-free retirement plan. It’s actually one of the few ways to exceed the yearly $18k contribution limit: Contribute the max, write yourself a loan with a high interest rate, then repay it plus the interest.
When NOT to do this
Now, if you were to Google using your 401(k) to pay off student debt, every article out there sounds like a drug commercial: They spend 25% of the time explaining how to do it and then 75% of the time warning you about all the side effects, and there’s a reason for that. A 401(k) properly invested in low-cost Index ETFs should conservatively return 6-7% annually over a decade or so, and if you use that money to pay down debt you give that long-term growth up. So for the majority of scenarios, it makes no financial sense to do this. Specifically it doesn’t make sense to take a loan against your 401(k)…
If You Don’t Have Debt
If you’re thinking of using this strategy to access your 401(k) money tax-free, stop. It’s a loan, not a withdrawal. You have to pay the loan back, and you have to do it with after-tax money. So if you put pre-tax money in your 401(k), loan it to yourself, then pay the loan back with after-tax money, you’ve effectively done nothing.
To Pay Your Mortgage
Americans can take out a loan from their 401(k) to pay down their mortgage. Canadians can do this via the Home Buyers Plan (HBP) if you’re a first-time homeowner or using an RRSP mortgage if you’re not. But because mortgages are in the 3% range, it makes no sense to sacrifice 6-7% long term growth to save 3%. And for Americans, your mortgages are tax deductible so it makes even less sense.
To Pay Off High-Interest Consumer Debt
While on the surface it seems like a good idea since the interest rate on credit cards can be north of 20%, if someone’s in that much credit card debt they’re probably an idiot who can’t manage their cash flow. And the last thing you want to do for an idiot is to give them access to MORE money, because they’ll just fuck that up too.
Plus, even if the person isn’t an idiot and the debt came from something bad that happened outside their control, it makes more sense to not touch their 401(k) and declare bankruptcy. Credit card debt can be discharged, but 401(k)’s generally can’t be touched. So it makes no sense in this scenario.
If You’re Working for the Government or a Non-Profit
Doctors, lawyers, and professors, take notice! All of you are groups that tend to have very big student loans but at the same time tend to work for government or non-profits. Namely hospitals, DA offices, and universities. You guys and gals are eligible for the Public Service Loan Forgiveness Program (or PSLF), which forgives your loan after 10 years. Do that instead of raiding your 401(k).
If You’re not American
There’s a reason I called this a 401(k) loan and not a 401(k)/RRSP loan. Only Americans can do this.
But if you’re not American, this is not a reason to be jealous. At all.
While I can’t speak for every country out there, our biggest non-US audiences are Canada, the UK, and Australia. And all 3 have what I like to call “Useless Degree Escape Hatches.” That is, if you get into a ton of student debt getting a PhD in Butt Waxing and can’t find a job, there are ways to have your loan forgiven. All 3 countries I listed don’t require you to pay anything if you earn below a certain threshold, and if your income never rises, eventually the loan goes away after a certain period of time because those governments don’t want student debt to hang over your head forever.
America doesn’t have that. Even the Income-Based Repayment (IBR) plan that resembles the programs in other countries designed to help if you can’t find a high-paying job only lowers the minimum payment and prevents you from going into default. It doesn’t help pay for it, and the loan keeps compounding under IBR. And even their forgiveness program that’s supposed to forgive the loan after 20 years isn’t that forgiving, because it makes the amount forgiven taxable income, which just transfers the debt from a student loan into an IRS debt.
So while this option isn’t available to non-Americans, there are far easier ways to get out of crushing student debt for those readers. So use them.
So Who Should Do This?
The only scenario that we’ve come across in which this makes sense is the exact scenario we’ve outlined above: An American with a lot of student debt (hard to find, I know) who’s working in a for-profit company, whose company offers contribution matching.
The IRS also only allows a 401(k) loan up to $50k, or 50% of your 401(k) balance, whichever is less, so if you have >$100k loan, this strategy may only partially help. But since American student debts are graduated (meaning, every loan for every year has its own interest rate), definitely do this for at least your highest-rate loans.
And as always, double and triple check with your 401(k) plan operator and a tax professional before you implement anything. Rules may vary based on your employer’s plan.
And with that, we’re done for the week. What do you think? Is taking 401(k) loan a smart strategy for tackling your student debt? Tell us in the comments!
And for another take on this subject, Revolutionary and fellow blogger Angry Retail Banker also talks about this in his blog post Should You Use a HELOC to Pay Off Your Student Loans.
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