Tuesday, June 21, 2011

Why I'd rather take out student loans than dip into my 401k

As I get closer to the point where I have to pay my fall bill, I'm running and re-running the numbers on how much and how I can pay.  The good news is that I'm fairly certain I can pay for my first year including living expenses in cash. The bad news is that I'm facing an estimated $25,000 gap in my expenses for next year based on my current assets.  There are many ways I could fund that gap without having to take on credit card debt (thereby protecting and maintaining my high credit report score) including potentially a combination of working more, living on less, withdrawing funds from my Roth IRA, taking out student loans or withdrawing money from my 401k  But I know one thing for sure.  I'm leaving the 401k money alone.  I'd rather take out student loans than raid my 401k.

Let's run the numbers.  Assume I can save $4,500 from my internship or work next summer towards my bill for next year making my outstanding gap $20,500.  The amount saved isn't important, it just makes the numbers work out nicely since $20,500 is the limit on Stafford loans for one year.  I can either fund the $20,500 gap through either student loans or my 401k.

So let's compare the two.  First, if I use student loans, I'll be taking out subsidized and unsubsidized Stafford loans.  These are Federal loans and generally have some of the more favorable terms available to grad students.


Loan type
Amount
Origin. fee
In School
Rate
Bal. at grad
Sub. Stafford
$8,500
1%
0
6.8%
$8,585
Unsub. Stafford
$12,000
1%
6.8%
6.8%
$12,936


The table above shows the break down of the two types of loans, the interest rates while in school and after, and the balance at graduation. So the assumptions around the student loan funding option are as follows:

Student Loans
Gap
$20,500
Interest Rate
6.8%
Balance at graduation
$21,521
Monthly payment
$662.54
# of payments
36
Total interest paid
$2,330


I'm assuming that I can pay off the student loans in three years after graduation which seems conservative enough.  The payments and interest paid are calculated around that assumption.

Second, I have the option of withdrawing funds from my 401k.  However, I'll pay a penalty of 10% on that money as well as having to pay income tax on it.  So I'll have to withdraw more than $20,500 in order to have $20,500 left after taxes and penalties to pay my expenses.

401k
Gap
$20,500
Federal tax rate
15%
State tax rate
5%
Penalty
10%
Withdrawn from 401k
$29,286
Investment return
6%

So I'd have to withdraw $29,286 from my 401k to fund the $20,500 gap in expenses.

Okay, we've outlined two options and some assumptions. Let's further assume that I'd either put money in my 401k or use it to pay my student loans. I'll ignore the fact that you contribute pre-tax to the 401k and use post-tax money to pay student loans.  We're also ignoring the tax deduction for student loan interest. So how does this play out:



2011
2012
2013
2014
2015
2016
401k
Retirement accounts
$70,000
$44,914
$47,609
$58,416
$69,872
$82,014
Loan balance
$0
$0
$0
$0
$0
$0
Net
$70,000
$44,914
$47,609
$58,416
$69,872
$82,014
Loans
Retirement accounts
$70,000
$74,200
$78,652
$83,371
$88,373
$93,676
Loan balance
$0
$20,500
$21,521
$14,828
$7,665
$0
Net
$70,000
53700
$57,131
$68,543
$80,708
$93,676

At the end of the day the student loans win by a long shot.  With the assumptions I've made I come out over $11,000 ahead by taking out student loans instead of dipping into my 401k savings.  This difference would be higher with better investment returns and if you account for contributing pre-tax money into your 401k instead of using post-tax money to pay student loans.  Assuming I'd contribute twelve times the monthly student loan payment to my 401k isn't accurate; I'd likely contribute around 50% more than that to the 401k to see the same effect on my available cash.  On the other hand, student loan interest paid is deductible, but I'm only paying about $2,300 in interest over the life of the loan.   So overall I'm probably underestimating the benefit of taking out student loans instead of withdrawing money from my 401k.

The big caveat here is that most MBAs will be leaving their employers before starting school and could roll their 401k money into an IRA which has much more favorable terms for withdrawals used for qualified educational expenses.  I won't be, however, since I have a solo 401k and may be able to contribute to it a bit while in school and (hopefully) won't need the funds either way.  We know that obtaining a masters of business administration can get expensive, but there are at least some reasonable options.

What would you do in this situation?

If you like this please Link Back to this article...



Related Posts by Categories



8 comments:

  1. If you are torn between the two, taking the student loan is always better. You also can vary the repayment of the student loan to fit your needs when you graduate, so you have a lot of flexibility.

    ReplyDelete
  2. I would talk out the loan just to avoid the tax penalty of withdrawing from the 401K alone. Now, if it has been a Roth IRA there would have been no question to me.

    ReplyDelete
  3. why not consider 3rd option to take load from 401k that you must pay back. so no penalty 10% or anything like that. better pay back the interest to your self rather than pay the interest to anyone else.

    ReplyDelete
  4. Btw, you will not get 6% return per year on your 401K between now and 2016.

    ReplyDelete
  5. Great job crunching the numbers. You should never touch your solo 401k plans. The government discourages you to do this by having some intense penalties for doing so. It is best to not touch your future. Take a second job to get through school.

    ReplyDelete
  6. Thank you for the great information.

    ReplyDelete
  7. Save, plan & pay for a college education. Private student loans, online banking, college loans, scholarships, undergraduate & graduate Fast Cash Advance student loans.

    ReplyDelete
  8. Superb, what a blog it is! This website gives useful facts to us, keep it up.



    My homepage: pilgrim Jewellery stockists

    ReplyDelete