Monday, December 3, 2012

Cash in 401(k) to Pay Off Student Loans?

I need to cash in on this book thing.
Pay off your debts, and write a book about it. 
How cool is that?

An opportunistic fellow has put up a website to document his "struggle" to pay off his student loans from Harvard, which total, or totaled, $90,000.

Graduates from Harvard are rarely in danger of defaulting on Student Loans, particularly those making $74,000 a year, which is a lot of money for a young man out of college to be making.   The general "rule of thumb" of student loans is that you should not borrow more than the first year's salary in the job you expect to get after graduation.  And with a $90,000/$74,000 ratio, this fellow was not far off the mark, and hardly "stressed" with student loan debt.

Others are not so lucky.

Should you make heroic efforts to pay off student loan debt?  It depends on a number of factors, including the loan types and interest rates.  When you are in your 20's, having tens of thousands of dollars in debt may seem like an onerous burden that will never be paid off.   And we see this all the time with these idiotic "Wall Street Protesters" complaining they have $25,000 in debt and will "never pay it off" - while most Americans pay that for a car and pay it off in four years or less.

Clearly, the perspective of youth is skewed.

One intrepid reader set out to reduce or pay off his student loan debts right out of college, by finding a high paying job and applying all his resources to retiring that debt.   Good for him!   But is it always a good idea?  Again, this depends on a number of factors.

As I have noted before, paying off a debt is like a 100% sure-thing investment.   The principal paid off is a debt retired, never to be paid again, and thus represents a "sure thing" in terms of increasing your net worth (usually from negative to positive).   The interest not paid is also a "sure thing" in terms of a return on your dollar.   If you retire a debt early, you may save hundreds, thousands, or tens of thousands of dollars in interest charges.

And of course, one ancillary effect of paying off debts is that it reduces your cash-flow requirements, effectively making you wealthier in terms of how much disposable income you now have, how long you can live on your savings, and how soon you can retire.

But "sure thing" safe investments are really more the province of older people.  At least traditionally, old folks were the ones who invested all their money in government bonds and had their mortgages and cars paid off.   At age 65, Granny can't afford to be risking her livelihood on risky stocks and be burdened by debt.  And traditionally, this is why people used to be able to afford to retire on modest pensions that were a fraction of their working salary.  With their house paid for, no debts, and lower expenses, they could get by on hardly anything.

Of course, today, this has all changed.  Old people, like my neighbors, are retiring with debt, including mortgage debt - and taking on new debts in the form of auto loans and the like.   Recent generations have retired with pensions equal to 2/3 to 3/4 of their final salary, particularly if they worked for government.  Our generation - the 401(k) generation - may have a different paradigm to wrestle with.  We will have to retire on our savings and with no pension, this could be a much different - and harsher - scenario to deal with.

And that is why I am debt-free at 53 and my neighbor is refinancing his house at 73.  He has a pension, and looks at life as a series of payments.  I have a 401(k) plan, and look at life in terms of net worth.   This was the goal of the GOP in pushing for elimination of defined-benefit pensions, and it seems to be working.   Our generation has to be more fiscally responsible - or else.

But what about our 20-something friends?  Should they be paying off debts early in life?   It is an interesting question, with a lot of angles to consider.  My thought is this:   Try to avoid taking on debt in the first place, when you can.   As for paying it off, take a balanced approach.

One of the conflicts that occurs with the young is that, having debt, they are also encouraged to save.   These two goals conflict, and often can result in a person leveraging themselves into oblivion.   Before the Real Estate Meltdown of 2008, many folks thought they were "rich" because they had a fancy house that on paper was worth more than they owed on it.  And their 401(k) plan had a hefty balance on it, which was more than the balance on their mortgage.  On Paper, they were wealthy.

But in 2008, the value of the house plummeted, and suddenly they were "upside down" on their home, and their 401(k) plan dropped in value as well, and it no longer exceeded their debt load.   People went from wealthy to insolvent, literally overnight.  And they realized, for the first time, how heavily leveraged they were.

Trying to save money while in debt has this effect - you are in effect leveraging your debts, particularly if you put money in to a tax-deferred account, such as an IRA or 401(k) where the taxes and tax penalties would be brutal, if you decided to withdraw the money to pay off debts.  And many folks have asked, "Can I use my 401(k) to pay off my mortgage?" and my conclusion was, it was a bad idea.

Getting back to our topic (background is everything), one of this fellow's ideas on how to retire this debt is to cash in an IRA plan.   Was this a good idea, or just a stunt?  Well, in my mind, just a stunt.  Actually, the whole website is just an attempt to garner some fame for the author (he is selling a book on the subject).   His debt load was hardly onerous on a salary of $74,000 a year, and his real problem was not student loan debt, but his $1300 a month "entertainment" budget.  Once he cut back on spending, not surprisingly, he was able to cut back on debt, rather quickly.

And the reality of his situation was that he cashed in a paltry $8000 IRA (probably set up by his parents while he was in college) while still contributing 10% of his income to his 401(k).  He was hardly robbing Peter to pay Paul, or sacrificing savings to pay off debts.   The headlines in the popular media that he "cashed in his 401(k)" were misleading and exaggerated.

But lets look at this.  Does it make sense to contribute to a tax-deferred savings plan while still servicing debt?  This analysis would depend on a number of factors - the loan interest rates, the rate of return on savings, and the tax advantages of the tax-deferred savings plan.

Let's assume a 4% loan interest on the student loans.  From what I am reading online, this is not an atypical rate.  From a recent Forbes article, this seems to be about right:

"Undergraduates are eligible to receive two types of Stafford loans: subsidized and unsubsidized. With the former, the government pays the interest while students are enrolled at least half time, and the rate is set at 3.4 percent. In the latter case, students accumulate interest while in school, at a current rate of 6.8 percent."

However, private loans can be even higher.   And one trap young graduates often fall into, is the offer to "refinance" guaranteed student loans (which have low rates and short terms) into variable-rate notes over 30 years.  I would not recommend this.

For purposes of illustration, let's assume his IRA (or 401(k)) had an even $10,000 and let's compare this to $10,000 in student loan debt.   Let's also assume that the IRA is making 7.5% per annum, over time, which is not an unreasonable rate of return on the stock market, over time, even for a fairly conservative portfolio.

You start to see how many variables there are here.  Let's throw another one in - tax rates.  At $74,500 a year, he is firmly in the 25% bracket.   Again, for the purposes of illustration, we will assume his marginal bracket stays the same - 25% at both ends of the transaction.

Which leads to a first fallacy.  That $8000 IRA he had was likely set up at a time when his income was in the 15% bracket, if that.   As a result, he is paying taxes at the rate of 25% on money that he took a tax deduction at the 15% rate.  But let's let that go, for now.

On the $10,000 cashed in, he would have to pay 25% in taxes, or $2500, leaving $7500 applied toward his debt.  In addition, there is a 10% tax penalty, or another $250 in taxes, leaving $7250 to apply toward debt.

Now, if the term of the loan is set at 10 years (yet another variable - we are up to what, six already?) let's crank some numbers.

$10,000 in student loan debt, at 4% interest, would amount to $14,802.44 in ten years.  In other words, if he paid off $10,000 in debt at year zero, he saves $4802.44 in interest (I am not calculating this as a "pay down" situation over ten years, as this is an additional $10,000 in principle he is knocking off.

$10,000 invested in the IRA/401(k), over 10 years, at 7.5% interest, yields $20,610.32 - potentially, more than doubling his money.

Right off the bat, you can see that cashing in the IRA/401(k) doesn't seem like such a swell idea - based on a lot of assumptions I am making.  Student loan interest rates, for private loans, could be higher.  And the rate of return on the stock market is anything but guaranteed, of course.

But let's plug in the tax consequences.   Using our assumptions, the IRA money could double in value over ten years.  However, the real $7250 in paydown from the IRA would really only eliminate $10,731.77 in principle and interest over a decade - a savings of  $3481.77 in interest not paid.

In other words, he comes out at least $7128.55 behind - nearly the amount realized from the 401(k)/IRA by cashing it in, as opposed to leaving the money in the bank and making payments on that $10,000 over time - assuming our assumptions about rate of return and loan interest rates are true.

But what if his IRA doesn't earn 7.5% (which it easily could have, in the post-2009 stock market boom of the last three years)?   Suppose the rate of return on his IRA was a paltry 3% - along the lines of a 10-year treasury bill and one full point lower than his student loan interest rate?

The IRA is now worth only $13,439.16 after three years, or a gain of $3439.16.   What is interesting is that this almost exactly the same amount ($3481.77) in interest not paid on the student loan.

In other words, even if the rate of return on the IRA is a paltry 3%, you break even, even if the loan rate is 4%.    You can still come out ahead even if your loan rate is higher than your rate of return in the market, in some cases.

This is not to say this is always the case.  I am making a lot of assumptions here.   It certainly makes no sense to use this argument to extend the loans to 30 years, pay the minimum amount, and then contribute as much as you can to tax-deferred savings.

No, that would be extremist.  And I hate extremists.

I think a better balanced approach is as follows:

1.  Take on as little debt as you can:   This fellow admitted he had a huge "partying" budget, and I'm guessing that it started in his college years.  It is tempting to "live large" as a student, as they throw student loan money at you.  But if you can do without, borrow a dollar less, it pays off, over time.  Bear in mind that interest on student loans accrues while you are in college, so a dollar borrowed is often $1.25 by the time you graduate - and will cost you $2 to pay off, over time.

2.  Don't Extend Loans:   You will be pummeled with offers to refinance your student loans over 30 years, which could drop the monthly payments in half - but sign you up for perpetual debt, often on onerous terms.  Bite the bullet and pay them down in 10 years or whatever the original term was.

3.  Don't Try to Accelerate:  It may be tempting to "pay down" this debt early on, but don't sweat too much about paying them off sooner than that.  Money is scarce early in your career, and you should think about building up a "safety net" of personal savings, as well as starting funding for retirement.

4.  Contribute to Tax-Deferred Accounts:  Not saving because you have debt makes no sense at all.  While paying off debt is a "sure thing" in terms of rate of return, as a young person, you have time on your side and can cash-in on long-term gains.  To avoid saving merely because you have debt is to not save.   Again, balance savings with debt service.   Too much of one and not enough of another is never a good thing.

5.  Avoid Taking on More Debt:  This was the big mistake I made.   While I had ten years of student loans to pay off, I took on more debt in the form of credit cards, car loans, and a home mortgage.  The latter, like student loan debt, might have been unavoidable (if you want a place to live and plan on living somewhere for 10-20 years) I did not "need" auto loans or credit card debt.

6.  Realize that You Will Outgrow Debt:   While $38,000 seemed like a lot of money when I borrowed it, by the time I paid it off, it seemed a pretty trivial amount.  Today, people pay that much for cars (although they shouldn't) without batting an eye.  By the time I made the last payment on my student loans (my last SLS graduate loan was paid off in 2007!) this did not seem like such an onerous amount.

While I never accelerated (by much) the payoff on my student loans, at least I never made the mistake of extending them out to 30 years with a refinancing.  My mistake was in taking on additional, unnecessary debts when I could have been saving more.   I still ended up doing OK, but I could have done much better, had I learned that "doing without" wasn't all that bad, and in fact, probably better than "doing with".   My $1700 Mercedes was five times as much car as my $25,000 Taurus.  And I drove both about the same amount of miles before selling them.  One cost five times as much to own, and was 1/5 as enjoyable.

While I have to congratulate the fellow for paying off his $90,000 debt from Harvard, I am not sure it was such a great accomplishment on a $74,000-a-year salary.   And while I hope he learned a lot from the experience (how to live on less and accumulate more wealth) from reading his website, I am not sure he learned much.   As he paid down debt and as his income increased, it seemed like he went back to a lot of his "old habits" in short order.

Any guy who pays $600 for a brake job on a Honda, needs to have his head examined.