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.