A little while ago, I wrote about my roommate’s decision to pursue a full time MBA.
Of the many discussions we had around the topic, a very interesting one came up.
He was looking at the total costs adding up and the amount of student loans he was going to need were going to be incredibly high.
As I had mentioned, he was estimating that the total costs for everything (tuition, books, living expenses, etc.) would cost nearly $200K.
He had a good amount of money in cash saved up, but he was still thinking he would need to take out up to $175K in loans. That’s a massive amount for anyone!
Knowing this, he was looking at as many options as he could to bring that number down.
One such avenue he stumbled upon: Partially paying for grad school with the funds in his 401K.
Is that a wise move? Let’s dive in a little deeper.
Won’t There Be a Penalty?
Traditionally, if you want to access funds from your 401K and/or Traditional IRA prior to age 59½, you are subject to pay taxes upon conversion, as well as a 10% penalty for an early withdrawal.
This penalty is usually something you want to avoid at all costs, and why proponents of early retirement will turn to a Roth IRA conversion ladder to help avoid it while still accessing retirement funds early.
However, there is an IRS rule that allows the penalty to be waived if the distribution (or the funds you withdraw) is used for qualified educational expenses.
Qualified educational expenses include: tuition, fees, books, supplies, equipment, and room and board (if you are at least half-time).
Thus, my roommate is in the clear here. He can absolutely use 401K dollars to pay for some of his tuition without incurring the 10% fee.
Converting During A Low Income Year
Many grad programs are structured a certain way. For a 2 year program, many will actually last 3 calendar years.
Year 1 will start in the fall, Year 2 will be the spring and fall, while Year 3 will finish in the spring.
More likely than not in Years 1 and 3, you would have a full time job in which you would be earning a full income for part of it.
However, in Year 2, you are either in school that entire year or just working a couple months during the summer.
This will translate to a year of low income, and thus a lower tax bracket.
Going along with this strategy, you could take out your student loans in segments. Use Year 1 to take out enough student loans to get you through the first year.
Then in Year 2, when you have a very low income, you could convert your 401K or IRA to pay for some of your tuition expenses penalty free, while also paying minimal taxes on that.
Even if you don’t choose to use your retirement savings to help pay for grad school, this middle year is a great time to convert some of your pre-tax retirement savings to a Roth IRA, while paying minimal taxes on that.
What About Interest Rates?
Student Loans come in all shapes and sizes.
Right now, for graduate students, Direct Unsubsidized loans come in at 6% and Direct PLUS loans are at 7%. These increase to 6.6% and 7.6% next month.
That is not a small rate, and not all people even will qualify for these loans.
If you don’t qualify, you will have to get loans on the private market. The interest rates you get here can vary, though the average is between 9%-12%.
All of those loans begin accruing interest the moment you take them, so even during school they rack up interest.
This is where my roommate was a little worried. He did not qualify for getting all his loans at the 6%-7% range, meaning he needed to get some from the private market, likely at the even higher rates.
Taking out nearly $175K worth of student loans with interest rates in the 6%-12% range will lead to an enormous amount that needs to be paid in interest against that.
He was thinking that by using those 401K dollars, he would be able to take out less of the private loans at the incredible high interest rates.
Should You Use Retirement Savings to Pay For Grad School?
This was the point of this post, and yet it is a tough question to answer.
Looking at historical market returns, the annual inflation adjusted return on the S&P 500 is 7%.
Looking at it side by side, the interest rates (6%-12%) seem to be higher or even with the average market returns (7%).
Does this mean that using 401K dollars to eat away at the loans is the right move?
Not necessarily, because there is already a balance in your 401K/IRA, the growth compounds on itself. Give it enough years, and that will grow into a huge sum and potentially even outpace the interest on the debt.
For instance, if my roommate had saved up $30K in his 401K, without contributing a single dollar more to it that would grow to $450K at 7% average annual returns 40 years later at a traditional retirement age.
Given that knowledge, it may be beneficial simply to keep that as it is, and simply focus as much money as possible in paying off those student loans when finished with grad school.
On the other side, perhaps you are more pessimistic about future market returns.
Or maybe you are extremely debt averse and aware of the toll that being in a debt can take on your mental health.
In this case, perhaps it is beneficial to use the 401K funds to help lower your initial student loan debt and thus be able to get rid of it faster.
What’s the Right Move?
Unfortunately, there really is no clear answer.
Depending on what assumptions are used (total student loans, interest rates, 401K balance, starting salary, market returns, etc.), you could realistically make a logical argument for either scenario.
Ultimately, my roommate ran his own numbers (he was a finance guy like me) with his own assumptions and determined that using his 401K to help drive down the total student loans he needed to take out would be in his best interest.
For him, if he gets the $130K+ salary that is the average coming out of the school he is attending, it likely won’t matter too much, as he plans to eliminate the debt as soon as he can.
With a salary that big, the debt can be repaid very fast, especially if you are living modestly.
Personally, I’ve already ruled out going that much into debt (not including a potential future mortgage). But if it were me in my roommate’s shoes, it certainly would be a tough and interesting decision to make.
What would you do in this situation if you were going to grad school? Is eliminating debt as fast as possible worth giving up potential future investment growth?