Student loans or retirement account?
May 2, 2011 2:14 PM Subscribe
Should I take money out of a tax-deferred retirement account to pay for graduate school?
I am enrolled in a graduate program that will end up putting me in debt. I worked for a few years and have some money (roughly one-third of a year’s tuition) put away in a 457 plan (which is like a 401(k) except I would incur no penalty for withdrawing the money early). It’s been earning a pretty good return lately, but obviously there’s no guarantee that it’ll continue to do so, especially in the short term.
Should I withdraw this money and use it to pay my tuition in the fall, in lieu of taking out more student loans? The loans would probably be at about 8% interest and begin accruing interest immediately (i.e., while I’m still in school). If I withdraw the money from the 457 account, I believe it would just be subject to regular income tax, and my income is negligible now, so I ought to be able to get close to the whole balance if I’m smart about it.
It seems to me that as long as the 457 grows at less than 8% a year, I am coming out behind by leaving the money in there. Am I missing something?
One other pertinent wrinkle is that there is a small but significant chance (say, 25%) I’ll end up working in a field that would eventually make my loan debt eligible for forgiveness. So in a certain sense, money I borrow now could end up being free money, should a very particular set of circumstances occur. If I take the retirement money out now, it's gone forever.
My father insists I should not do this, but I think it’s mainly out his general belief that one should save for retirement early and often; I’m not sure it makes sense on an actual accounting of the numbers. Thanks for reading, would appreciate any insights!
I am enrolled in a graduate program that will end up putting me in debt. I worked for a few years and have some money (roughly one-third of a year’s tuition) put away in a 457 plan (which is like a 401(k) except I would incur no penalty for withdrawing the money early). It’s been earning a pretty good return lately, but obviously there’s no guarantee that it’ll continue to do so, especially in the short term.
Should I withdraw this money and use it to pay my tuition in the fall, in lieu of taking out more student loans? The loans would probably be at about 8% interest and begin accruing interest immediately (i.e., while I’m still in school). If I withdraw the money from the 457 account, I believe it would just be subject to regular income tax, and my income is negligible now, so I ought to be able to get close to the whole balance if I’m smart about it.
It seems to me that as long as the 457 grows at less than 8% a year, I am coming out behind by leaving the money in there. Am I missing something?
One other pertinent wrinkle is that there is a small but significant chance (say, 25%) I’ll end up working in a field that would eventually make my loan debt eligible for forgiveness. So in a certain sense, money I borrow now could end up being free money, should a very particular set of circumstances occur. If I take the retirement money out now, it's gone forever.
My father insists I should not do this, but I think it’s mainly out his general belief that one should save for retirement early and often; I’m not sure it makes sense on an actual accounting of the numbers. Thanks for reading, would appreciate any insights!
Best answer: It seems to me that as long as the 457 grows at less than 8% a year, I am coming out behind by leaving the money in there. Am I missing something?
Technically, you're ignoring that this money grows tax-free until retirement, so its after-tax earnings are greater than a normal savings account. That is, if you wanted to earn 8% per year from a brokerage account, and your taxes averaged 5% of earnings every year, you'd have to earn 8.5% or so before taxes in order to actually end up with an 8% return.
But that's not the heart of your question... and I basically agree with your decision. Taking out fewer loans is really "locking in" an 8% return by not having to pay 8% interest. So you want to compare this to what sort of returns you could "lock in" in an investment, which would be some sort of safe bond. Do you see any safe bonds offering an 8% return? No--it's a really good rate.
This is a long way of saying that not taking out fewer loans is the same thing of taking out a personal loan in order to invest in the stock market. Some people do this, but it's pretty risky.
On the other hand, there's some "option value" to leaving the money in the 457. If you come out of school in a few years with debt and can't find a job, nobody's going to lend you money then. You might really appreciate having a fund you can tap if you absolutely have to. And nobody can force you to take the money out of your 457, not even in bankruptcy, I believe.
posted by _Silky_ at 2:44 PM on May 2, 2011 [1 favorite]
Technically, you're ignoring that this money grows tax-free until retirement, so its after-tax earnings are greater than a normal savings account. That is, if you wanted to earn 8% per year from a brokerage account, and your taxes averaged 5% of earnings every year, you'd have to earn 8.5% or so before taxes in order to actually end up with an 8% return.
But that's not the heart of your question... and I basically agree with your decision. Taking out fewer loans is really "locking in" an 8% return by not having to pay 8% interest. So you want to compare this to what sort of returns you could "lock in" in an investment, which would be some sort of safe bond. Do you see any safe bonds offering an 8% return? No--it's a really good rate.
This is a long way of saying that not taking out fewer loans is the same thing of taking out a personal loan in order to invest in the stock market. Some people do this, but it's pretty risky.
On the other hand, there's some "option value" to leaving the money in the 457. If you come out of school in a few years with debt and can't find a job, nobody's going to lend you money then. You might really appreciate having a fund you can tap if you absolutely have to. And nobody can force you to take the money out of your 457, not even in bankruptcy, I believe.
posted by _Silky_ at 2:44 PM on May 2, 2011 [1 favorite]
Sounds like you have all the data you need to run the numbers.
Figure out a historical rate of return on the account for X years where X is how long it will take to payback the loan, subtract the tax amount you'll pay for the withdrawal. This is how much the 457 money is worth.
Figure out the total cost of the loan at the current interest rate if paid of in X years (same number as above). This is how much the loan is worth. If this amount is greater then the 457 money number then its worth it to withdraw the money.
Sounds like you're right on the cusp where its about a dead heat so you really need to run some projections with real numbers to find out where it makes sense. Generally I'm with your dad, student loans tend to be the lowest loan you can get, but there are tangible numbers to play with here to figure out what makes sense.
posted by bitdamaged at 2:45 PM on May 2, 2011
Figure out a historical rate of return on the account for X years where X is how long it will take to payback the loan, subtract the tax amount you'll pay for the withdrawal. This is how much the 457 money is worth.
Figure out the total cost of the loan at the current interest rate if paid of in X years (same number as above). This is how much the loan is worth. If this amount is greater then the 457 money number then its worth it to withdraw the money.
Sounds like you're right on the cusp where its about a dead heat so you really need to run some projections with real numbers to find out where it makes sense. Generally I'm with your dad, student loans tend to be the lowest loan you can get, but there are tangible numbers to play with here to figure out what makes sense.
posted by bitdamaged at 2:45 PM on May 2, 2011
One other thought: is your 457 from the government or a private employer?
If it's from the government, Wikipedia tells me you can roll it into other retirement plans, just like a 401(k).
Then you might look into rolling it into a Roth IRA this year (or some year of grad school when you have no earnings). You have to pay taxes on the conversion, but because you're in grad school and presumably earning very little money, your year-end tax bill might still end up being $0. And a Roth IRA is sweet--you don't have to pay any taxes when you take the money out of the account at retirement.
If the 457 isn't a government plan, Wikipedia says you can't roll it into an IRA, so ignore this.
posted by _Silky_ at 2:57 PM on May 2, 2011
If it's from the government, Wikipedia tells me you can roll it into other retirement plans, just like a 401(k).
Then you might look into rolling it into a Roth IRA this year (or some year of grad school when you have no earnings). You have to pay taxes on the conversion, but because you're in grad school and presumably earning very little money, your year-end tax bill might still end up being $0. And a Roth IRA is sweet--you don't have to pay any taxes when you take the money out of the account at retirement.
If the 457 isn't a government plan, Wikipedia says you can't roll it into an IRA, so ignore this.
posted by _Silky_ at 2:57 PM on May 2, 2011
How old are you? Time is the most important factor when it comes to your retirement savings. The earlier you start, the better you're off. Pulling that money out essentially resets your start clock an can cost you hundreds of thousands of dollars (depending on your age).
I vote don't do it.
posted by shew at 3:02 PM on May 2, 2011
I vote don't do it.
posted by shew at 3:02 PM on May 2, 2011
Take out loans that can be deferred while in school, and make this decision once you enter repayment and have a ton more information.
posted by SMPA at 3:27 PM on May 2, 2011 [4 favorites]
posted by SMPA at 3:27 PM on May 2, 2011 [4 favorites]
Is there any way you can use the retirement account as collateral for your loans, thus securing a lower loan rate while allowing your retirement funds to grow?
posted by kdar at 5:29 PM on May 2, 2011
posted by kdar at 5:29 PM on May 2, 2011
Borrow from the retirement account, then you repay the interest to yourself. The value of tax-deferred money is really meaningful over time, I wouldn't give that up unless it's the ONLY way to get the money.
posted by Lizzle at 10:28 AM on May 3, 2011
posted by Lizzle at 10:28 AM on May 3, 2011
Response by poster: Thanks guys, some really good ideas here to think about. Some of your suggestions have given me pause about taking the money out, especially since it really isn't something I have to do, just a question of costs and benefits.
posted by dixiecupdrinking at 3:17 PM on May 3, 2011
posted by dixiecupdrinking at 3:17 PM on May 3, 2011
Best answer: Sounds like you are on the right track but I want to add that if your likelihood of getting loan forgiveness is ~25%, there's no way I'd take money from retirement and potentially miss out on that windfall.
posted by screamingnotlaughing at 4:34 PM on May 3, 2011
posted by screamingnotlaughing at 4:34 PM on May 3, 2011
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