Thursday, January 7, 2010

Taking Loans vs. Cashing Out Roth IRA To Pay For Law School

In response to a recent post, I received the following comment:
What is the wisdom in paying for law school using money in a ROTH IRA as opposed to taking the money out in loans? I saved a lot in my teens and 20's for the money that's now in my ROTH, and I can't help but wonder if it would be a good idea to use it now (tax-free as a "qualified educational expense") to pay for law school instead of burdening myself with new loans.
Frankly, my first thought was "Geez.  Must be nice!"  My second thought was to give a tip of the hat to someone dilligent and frugal enough to save up a Roth IRA while in their teens and 20s.  Thinking about it a little more, most students that return to law school after their 20s may very well have some retirement assets set aside in a Roth, so we will take a look after the jump at some considerations and potential dangers involved in this decision.

A little disclaimer up front - this is not financial advice and I do not represent you.  This blog is for educational and entertainment purposes only - not investment advice.

Returning to the question at hand, for those of you that might be unaware, it is possible to take money out of a Roth IRA account for educational expenses.  However, it may not all be tax-free - as we will see below.

Here's a good backgound summary from Investopedia and here is the relevant publication from the IRS website.

In short, taking money out of a Roth IRA to pay educational expenses is a non-qualified distribution - not a qualified distribution (where qualified distributions are tax AND penalty free).  As a non-qualified distribution, it may be subject to both income tax and penalty.  However, a withdrawal to pay for qualified higher-education expenses is an exception to the requirement to pay a penalty.

However, you may have to pay income tax on the withdrawal from the Roth IRA if the withdrawal includes earnings in addition to your contribution to the Roth IRA.  For example, if you contributed $10K to a Roth IRA, the balance grows to $20K based on investment return, and then you withdraw the entire $20K, then the $10K or earnings is taxable as ordinary income.

In addition, there are a bunch of other little traps to be aware of like the Roth IRA must have been open for at least 5 years, and the tax treatment gets strange if you have previously done a rollover.  Here's an additional publication from the IRS that might help.  Also, be aware that the total that you withdraw from the Roth IRA must be less than the "educational expenses" of attending the school.  Otherwise, you get socked with a 10% penalty.

OK, so let's consider a hypothetical law student that has been saving up for law school and has a $20K Roth IRA, $10K of which was a contribution and $10K of which is earnings.  We note that the student can take up to $10K out of the Roth IRA tax free, but anything over 10K is going to be taxed as ordinary income.

Philosophically, let's assume that the law student wants to maximize their net worth at the end of law school rather than minimize their total loan balance.  Conversely, if the student just wishes to minimize their total loan balance, then distribute the whole IRA, pay the taxes and be done.

One other thing to note is that when we are comparing the (Roth IRA) RIRA distribution vs. an additional student loan is what are the types and costs of the loans?  For example:

1) Unsubsidized student loan -  This loan accrues interest from the time it is made.  At a first glance, the question of maximizing new worth seems to be simply one of interest rate arbitrage - that is, if the interest rate on the loan is less than the expected rate of return in th RIRA, take the loan.  However, we note some other interesting aspects to consider:
  1. We don't know the income tax position of the student (is there a spouse that works? does the student have other income?  This becomes important with regard to the distribution of the 10K based on earnings.  If the student is in the 28% bracket, then their 20K RIRA only provides $17,200 after tax - $2800 goes to tax.  Conversely, in certain other situations the student may pay zero income tax.
  2. Payment of interest on student loans may be tax deductible - up to $2500/year for families making less than $115K.  This is going to impact the effective interest rate that you pay on the loan - which is going to impact the comparison of the interest rate with the expected return in the IRA - but again, this is going to vary by tax bracket.  For example, if the student took out a $25K loan at 10% (requiring $2500/year in interest), but the student is in the 28% bracket, then the student's payment of $2500 really only cost them $1800 after taxes.  Thus, the effective interest rate is really only 7.2%, not 10%.  Conversely, if the student is in a low income tax bracket, then this will have less impact.  Additionally, if both the law student and the spouse are going to be working, then their income may exceed $115K.
2) Subsidized (Stafford) Loan - interest does not accrue and payments are not due while the student is in school.  Thus, the Stafford Loan is just interest-free money, where it is interest free for up to 3.5 years (remember the 6-month grace period after graduation).  Consequently, if a student is entering law school and considering whether to take the Subsidized Stafford Loan or cash in the RIRA, the student may wish to consider whether the RIRA will grow significantly over the next 3.5 years while the subsidized loan does not.  For example, assuming 8% annual growth on the student's IRA, the $20K IRA will have grown to $26,183 in 3.5 years while the Subsidized Stafford has not grown at all. 

However, the 8% growth is not guaranteed and the student may want to cash out the RIRA to pay for school to avoid any crash in the market.

Findings
With regard to the Subsidized Loan, I would lean toward taking the loan rather than cashing out the RIRA.  I could potentially have up to 3.5 years of interest-free money.  Further, even once the loan goes back into repayment, the interest rate is pretty low (6.8%), and I might be able to deduct the interest payment.  On a loan of 40K at 6.8% and a 28% tax bracket, that would lower my effective interest rate to around 5%.

One thing that I certainly would not do - I would not withdraw the earnings portion from the RIRA if I am going to have significant tax liability.  I am not going to pay tax now rather than using interest-free money for up to 3.5 years.


The question gets a lot more complicated and income-specific with regard to the unsubsidized loan.  You are going to have to figure out the actual costs using your specific situation.

However, if we simplify the issue by ignoring the tax implications, then the question becomes a comparison of the interest rate on the loan to the expected return on the RIRA.  However, with an unsubsized loan, about the best you are going to do in interest rate is 6.8% (unsubsidized Stafford) and you may very well end up paying 10% or more.

I it makes no sense to be paying 10% on a loan when the US stock market is likely to only return about 8% on average.  Also, even if the loan is at 6.8% and the US stock market is projected to return 8%, that 1.2% increase in return is pretty skimpy for taking on the additional stock market risk.

Here's another view - paying a loan is like investing in a security that has no risk of loss and produces a guaranteed return.  Above, we compared the interest rate on a loan to the rate of return in the stock market.  However, that's really an apples-to-oranges comparison because the stock market certainly does have a risk of loss.  Instead, pretty much the only simple investment with zero risk of loss is a CD -  and they are only paying about 2-2.5% right now (3 year CD).  Consequently, for similar investments, your rate of return is much higher by putting the money toward the loan.

Conversely, if the student has income from a spouse or job during law school, the amount of income tax that the student may have to pay may make it a bad deal to cash out the earnings on the IRA. 


Bottom Line
I would probably take the Subsidized Stafford Loans instead of cashing out my RIRA.  However, when it came to the unsubsidized loans, I would probably be cashing out at least the contributions to the (RIRA), and may be cashing out the earnings as well depending on my tax position.

Anyone else reach a different conclusion?  If so, why?

One other thing to consider- as I detail in this earlier post, especially with regard to subsidized loans it may be to your financial advantage to enroll in a community college after law school and just take a class or two - enough to maintain part-time status, and thus have zero interest accrue and not have to make any payments on subsidized loans.  You will have to take a look at the specific community college costs in your area and the loan interest rates.

10 comments:

  1. If he knows what a Roth IRA is, he's too smart to go to law school.

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  2. Will - Lol! Actually, he's already in law school or I would have given him more of the old "have you considered the financial repercussions of attending law school? I have some posts I want you to view - and check out some of the blogs that I link to, too!"

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  3. Thanks again for your blog. Since you seem amenable to post ideas, I have a few:

    -- My fellow associates have a vague idea that they 'should' be saving for retirement, but don't understand why waiting just five years is so detrimental. I've tried explaining the power of compounding to a few, but to little avail.
    -- I think many associates errenously think that renting a place to live is always throwing money away, while buying a house is always good, not understanding that they're investing (or "investing") on borrowed money in an asset that may not appreciate it at all.
    -- Alternative Minimum Tax and, relatedly, overvaluing tax deductions. This connects to the previous point; if you're a young associate with a spouse and a dependent child in a high tax area, you may not even be able to deduct your mortgage interest. I have been surprised how many don't factor that in before deciding to buy a place.

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  4. 12:36 - Thanks for the suggestions! I will address at least the first and second points in upcoming posts. Thanks!

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  5. A few rambling thoughts about the community college thing.

    1. I actually think it's funny that the loophole even exists. At one point, I randomly decided to take a summer class somewhere and was surprised that my loans were put on hold for three months. While I understand that it might be a good thing for loans to be put on hold for someone who is pursuing another degree, I would think that sometime in the near future either the government or the loan companies themselves will lobby the govt for a change so that people who take a class or two don't get to put a hold on their loans.

    2. At one point after I was cut from a previous job, I had thought about going to community college and owner a bakery or something along those lines. It was a weird thought. I was excited when the community college promoted programs by the state that said if you were recently cut from your job, your tuition would be free. But then I read the fine print. People who have already attained a bachelor's degree or above would not be eligible for that problem. I wasn't angry, but disappointed. My mom said to me "those programs exist to help the poor. You are not poor. Stop trying to take advantage of the system."

    In a sense, I kind of agree. But also, in the big picture, the entire concept of a community college is to help the poor. I can't imagine why they would even allow people who already have bachelor's degrees enroll, much less professionals who are enrolling into a couple of classes just for kicks or worse yet, for the sole purpose of putting loan payments on hold. Every spot a professional takes up is arguably one less spot for someone who really needs it. I would imagine that community colleges might start looking into this and addressing that loophole as well.

    I'm not saying that a lawyer or MBA can't legitimately want to change careers and do an associate's in graphic design (or whatever). But for those who are just taking a few classes for fun, maybe they should have to take those classes at a for-profit college like the Arts Institute or something of that nature.

    3. Along the lines of professionals going to community college, I once knew of a kid who went to a very prestigious high school. She was obviously very smart. In the eleventh grade, she decided to take the GED just for kicks. She did well on it. Subsequently, she got kicked out of her high school because she was already technically a high school graduate. lol. Biggest backfires in the history of mankind!

    Ok, sorry for the long post. It's just something I had on my mind about community colleges being used by professionals instead of by blue collar types.

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  6. Hi Coder Emeritus - Interesting thoughts! Community colleges can certainly vary in attendance and quality, especially geographically. For example, here in the Chicago area we have the College of DuPage (COD), a community college with 31,000 students and several campuses. According to their website, about 20% of their students already have a bachelor's degree. COD offers programs and certifications that are not available elsewhere, such as a plastics manufacturing certification. They also have classes for nurses including cadaver anatomy. To me, community colleges like COD are less about a sociological class divide of rich vs. poor and more about a style of learning. For example, community colleges offer practical courses to be applied immediately by people already working in the business/trade/medical world - and they typically offer these courses in a way that accomidates a commuter/worker schedule. Conversely, conventional universities offer more theoretical courses that are often of less immediate practical use and are intended to build toward a degree - they are also typically full-time. Community colleges are also a great resource for those in the community that like to learn things to satisfy their own interests, like learning a new language, for example.

    Frankly, I don't agree that community colleges are to help the poor. Instead, I would suggest that they should provide practical training so that people that find themselves out of work can re-train for another career quickly - in order to keep our economy humming. In that regard, your state's decision to exclude those that had already attained a bachelor's from having free access to the community college seems kind of discriminatory. It seems to equate education with income, which is certainly not the case. For example, there are a lot of HVAC technicians, electricians, and plumbers making a lot more than people with English degrees - or law degrees, for that matter. If the objective of providing free classes was to get people back in the workforce faster, then it seems like it should probably have been extended to everyone.

    I spent some time in the New England area for law school and some of the sentiments that you express seem like those that were expressed by people there. I had never heard the sentiment of "you are not poor, therefore you should not be allowed to go to a community college" expressed in Chicago where I grew up, but it seemed to be accepted wisdom in the New England area. Strangely to me, it was still OK in their minds to go to public libraries and use other free or low-cost public services - it was just the communitiy colleges that seemed to be verboten. Frankly, I wondered if it was more of a "class" thing than a "poor" thing. There was a lot more focus on "class" in Boston than I had ever seen in Chicago. In Chicago, it seems like everyone's an immigrant - and if it's not you, then it's your parents or grandparents - and immigrants are typically not big on "class" distinctions.

    Let me be clear that this is not a personal attack and I mention my experiences in the New England area to give credence to your point and agree that there are indeed people who think like you do about the issue. I thank you for your comment and opposing view - sometimes its the debate that can make things interesting.

    If I could figure out how to do it technologically, I think it would be interesting to have some kind of poll where people rate where they are from geographically and then indicate how they feel about the issue. My initial thought would be that many people from the New England area would agree with you, while many people from the Midwest would not.

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  7. Hi Managing Partner. No worries, I did not take offense your disagreement about the role of community colleges. It is indeed probably a product of how I was raised or the environment in which I was raised.

    I am from the Northeast, though not New England. I took a little bit of Anatomy & Physiology that involved human cadavers. It wasn't really my cup of tea. But I also know someone who took anatomy at a community college, and I was very surprised they had such a class because I didn't think community colleges would have access to human cadavers. (I took at an institution which had medical students.) It turned out that my friend's anatomy class at the community college had animals for their anatomy lab instead of human bodies. But it's interesting you mentioned that in Chicago the community colleges have access to that.

    Okay, enough from me. have a wonderful weekend.

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  9. Thank you for sharing such great information. It has help me in finding out more detail about Educational Loan for Mba

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