In part one of this blog, we explored some of the reasons why using a 401k/403b loan to pay for college can be a risky strategy. In part two, we will talk about some of the additional challenges of that strategy and some alternative options.
The Five Year Repayment Period and Paying for College
The main benefit of borrowing is that the borrower can reduce the individual payment amounts by making more payments over time. People who borrow do so because either they do not earn income fast enough or do not have enough money left after they pay their other bills to meet the expense with current income. The five year repayment period on a 401k/403b loan is short for a loan, and these loans do not significantly reduce the size of the payments the borrower needs to make. If the student plans to be in college for four years and a parents uses a 401k/403b loan with a five year repayment term to pay for that education, a year’s worth of loan repayments (principal plus interest) will not be that much less than just directly paying for college.
No One Wants to Pay Taxes Once. Why Do it Twice!
Another strike against 401k/403b loans in general is very subtle. As you know from College Coach’s earlier blog about traditional 401k/403b withdrawals, contributions are made with pre-tax dollars, earnings are tax-deferred, and withdrawals from a 401k/403b are taxable. When a 401k/403b loan borrower repays their loan, they are paying the interest back to the account with after-tax dollars. Then, when they withdraw the interest in retirement, they pay taxes on the interest again. This is one of very few places where a taxpayer pays income tax on the same dollars more than once, and has the impact of making the loan more expensive than it looks.
Opportunity Cost: Lost Growth and Lost Matching
People who borrow from a 401k/403b often figure that because they are already making contributions to the account, they simply can change the contributions into loan repayments. While this might mean they won’t have trouble repaying the loan, there are other consequences. First, 401k/403b loan repayments are not matched by employers the way contributions are, so borrowers lose their employer’s match unless they can both repay the loan and make new contributions. Second, because the balance of the loan is not invested for the borrower, the account may not grow as quickly as it would without the loan. Yes, borrowers are paying themselves back, but the double taxation on the interest payments coupled with less exposure to traditional investments within the 401k/403b could have a big impact on the amount of funds available to employees when they retire.
So What Are the Alternatives to a 401k/403b Loan?
College Coach’s Paying for College experts help parents and students develop strategies to pay for their children’s college educations in the manner that works best for them. These strategies include:
- Identifying colleges that will be affordable to the family, either because they have a low sticker price or recruit the student with scholarships;
- Finding longer term education loans for the family to use that are not dependent on the parents’ employers;
- Identifying the family’s unnecessary spending to free up cash flow and allow the parents to pay for college out of current income