Found Money: Should You Use an Old 401(k) to Pay Off a Child’s Student Loans?
Parents generally want to help their children, even well into adulthood. This desire should be integrated into investors’ financial plans, as parents need to understand how it affects their finances and distribution strategy when portfolio assets are needed.
One situation we have encountered is when an investor has “found” an old 401(k) account at a previous employer and wants to use it to pay down their child’s student loans. For whatever reason, when leaving their former employer, the investor never rolled the account into an IRA or their new employer’s plan. The funds have grown over the years and have not been factored into the investor’s financial plan—essentially, “found money.” This type of mental accounting leads investors to treat money differently because it comes from an unexpected source. While most of us would love to miraculously acquire several thousand dollars, the reality is an investor’s net worth is no different than if all their money were in one account.
Money in a retirement account is meant for retirement, as the tax code incentivizes saving by offering tax benefits for contributions and usually penalizes those who withdraw money before the age of 59?. Right off the bat, whatever is withdrawn is reduced by 10%. Let’s say a $1,000 penalty on a $10,000 withdrawal. Next, regular income tax is owed on the withdrawal. If the child is old enough to be paying their student loans, chances are the investor is also in their highest earning years, meaning they’re likely in one of their highest tax brackets. A 24% marginal tax rate for a married couple filing jointly would be around $2,400 on the $10,000 withdrawal. Deduct $740 for state and local taxes, and that leaves $5,860 to pay toward the student loan. With the average student loan debt around $37,090 carrying an average interest rate of 6.87%, $5,860 knocks about two years off a 10-year payment plan.
The "Money Talks" hosts advise a family about the missed opportunities when taking a payout from a 401(k) to pay off student loans. Listen to the Podcast
When considering the choice between paying off debt and investing for the future, investors should compare the rate of return that can be earned on the investment versus the interest rate on the debt. The long-term average return for stocks is 10.5%, while the interest rate on student loans is around 6.87%. While it might seem counterintuitive, we generally recommend that investors do not stop saving for retirement. Especially with low-interest rate student loans, it often makes sense not to withdraw retirement money to alleviate the debt. Mathematically, investors should never want to take away money that is gaining more than the cost of the debt.
Even if an investor feels they have plenty of money for retirement, there are better ways to help a child financially. If an investor is saving to a brokerage account or emergency fund, a financial adviser can show the potential results of redirecting savings to help the child with the loans. Assisting a child with payments out of current cash flow can allow the adult child to take advantage of graduated payment plans, write off student loan interest on their tax return, and build credit by paying the loans regularly and on time.
If you have questions about managing debt while saving for the future, the experts at Henssler Financial will be glad to help:
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