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Should You Use Retirement Savings To Pay For Grad School?

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.

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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?

13 thoughts to “Should You Use Retirement Savings To Pay For Grad School?”

  1. I’ve never considered grad school, but reading this post I think he made the right decision! I’m debt-averse to begin with and those high rates would not make me feel good. Minimizing the loan amounts as best as possible would be my course of action.

  2. Oof, borrowing against my future by using my 401(k) would seriously worry me—probably because the bulk of my net worth is in my retirement accounts at the moment—and “if he gets the $130K+ salary that is the average coming out of the school he is attending” is a huge if. But then again 12% interest is no joke, either. I’d go your route anyway and decide the debt wasn’t worth it, so luckily I wouldn’t have to answer this question for myself in real life!

    Taking advantage of the middle calendar year to do some Roth IRA conversions is a good idea though!

    1. Totally agree that it’s a huge if, but even if he can’t get the consulting jobs that pay that well, he’s looking at a low side of $110-120K salary plus bonus which is still pretty darn good if you ask me haha

  3. I’m a bit surprised your friend could not get the entire amount via gradPlus loans since they normally will lend as much as the school claims is total cost of attendance.

    As for “if he gets the $130K+ salary that is the average coming out of the school he is attending”, I would suggest your friend be very cautious about simply accepting this number. Many MBA (and law school) programs tout a certain median salary, but once you get into the fine print (usually after drilling down through several pages on the school’s website), you learn that this is the median out of some percentage of reported salaries.

    Ok, what percentage of students reported salaries? Oh, it was only 50%? In the case of some programs, it’s as low as 25% reporting – there really ought to be an ethical rule that says a school should not be able to report ANY salary data if it’s based on less than half of the graduates… but I digress.

    Once your friend knows what percentage of graduates actually are in the reporting group, he’ll be better able to judge the investment. Especially if they give 25th and 75th percentile salaries along with the median.

    The other thing to note about the non-reporters is that they are much more likely to be below the reported median salary than they are to be above it (human nature, brag the good stuff, don’t talk about the bad).

    As for the value of the MBA itself, even if he finds that nearly everyone reported a salary and are included in the numbers, taking out $175K in loans (which will be more like $200K by graduation; as you note interest starts day 1) or spending similar amount from 401(k) for a $130K job is tough, in my opinion, to call a good investment.

    What is his situation now? Does he have an UG degree that could get him into a business analyst or marketing position in a company that might be willing (in a couple of years) to fund or partially fund him to get an MBA?

    1. Yea I’m just going with what he told me so I’m not sure why he wasn’t able to get the full amount.

      Definitely agree it’s aggressive to assume he’ll get that, but if he gets into a consulting firm that may be the low end to be honest. If not, he’s still looking at $110K plus bonus at minimum (since that’s what he can get going back to his old company which already offered him a spot back) which isn’t a bad backup plan.

      He thinks this is the best move for his career long term which is totally a personal choice. Me? I would go the route you mentioned and get my employer to pay for part time

  4. I put myself through school by working most of the hours I wasn’t studying. Like anything – hard at the time but pays off later. Debt is usually only good if you’re sure you can generate a much greater return than the cost of it. The whole trouble with most debt is the money is expensive because the lender is taking a hefty margin. The cheapest form of debt is where you can offer substantial security. For example a home loan with a low LTV, or better still, a margin account on your share portfolio.

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