Thursday, December 5, 2019

Should Retirement Funds Be Used To Pay Off Student Loans?

Senator Rand Paul has a new proposal out to (among other things) allow retirement savers to make tax-free withdrawals from their retirement accounts in order to pay down student loans.  The press release describes the plan this way:

As U.S. student loan debt hits its highest-ever levels, Dr. Paul’s HELPER Act would allow Americans to annually take up to $5,250 from a 401(k) or IRA — tax and penalty free — to pay for college or pay back student loans. These funds could also be used to pay tuition and expenses for a spouse or dependent. 

Why his office refers to him as Dr. Paul and not Senator Paul, I cannot fathom.  If I ever get elected to anything and start introducing legislation, I'm not going to be calling myself "Professor" in the press release.

For people paying down student loans, this could result in a substantial tax savings.  Think about it from the perspective of a person lucky enough to make good money and have the funds available to make significant contributions.  Routing funds through the 401(k) account would reduce taxable income and make it possible to pay $5,250 a year with pre-tax money. 

I'm not sure why we need to launder funnel through a 401(k) account. We could also deduct student loan payments (interest & principal) from income as well.  I'm not sure how necessary it is to use the 401k structure here.  If we want to simply make student loan repayment tax free, why put a cap on the amount that is tax and penalty free?  A cap creates an incentive to pay no more than the cap each year. If the thesis is that getting rid of higher interest rate debt early is a good idea, a cap may cause slower repayments.  

Consider a new doctor, heavily burdened with debt.  It may make sense to spend another year living like a resident and clear out the debt.  This is harder to do if higher tax brackets eat up much of the money earned.

Whether this proposal will, on balance, result in greater retirement savings at retirement, I do not know.  Its possible that some people may increase their 401(k) contributions to pipe student loan repayment money, tax-free, through these accounts.  Once the pipe is set up and running with a higher contribution level, they may continue those contributions after the student debt has been paid off.  On the other hand, some people might raid their retirements to get rid of student loan debt.

This may not be the best way to deal with student debt because it's an option that will only be available to those with retirement funds and accounts.  About half of Americans simply don't have any retirement savings.  If parents use their retirement funds to pay their children's tuition, it may simply reduce their retirement savings.  That being said, it might help some people and lead to better results for some savers than the status quo.

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