A friend recently sent me the following email:
“… here’s a question to challenge your finance column. I’ll make it a little hypothetical. “Our son graduated from 
college and is working to save money for graduate school. In college, he accumulated over $20000 in student loans (avg. 7%) and desires to pay them down ASAP by paying more then the minimum payment while at the same time saving money to attend graduate school. He recently found out that the company he works for has a matching 401K plan which in effect results in a 100% return. It so happens that a person can use money from a 401K to finance continuing education—paying a 10% penalty and normal income taxes.
Follow me? The question is “Would it be wise to pay the minimum payment on the student loans and sock the rest into the 401K anticipating pulling it out when it’s time for graduate school?”
401(k) for college? No way! Or…maybe.
My knee-jerk reaction was, “No. Never, ever take money from your 401(k) unless it is for an extreme emergency.” But as I pondered his question, I could see the logic of it. Instead of putting every penny against his 7% student loan, make minimum payments and throw every extra penny into his 401(k) in order to get the 100% match and then take it out (paying the 10% penalty and all taxes) when he starts graduate school, knowing that all student loans would be suspended at that time. He could defray his graduate school cost at that time, thus lessening his future student loan debt.
Although the idea still doesn’t sit well with me, I told him that it would probably work.
I also told him I would query my readers for their thoughts, so here is where you come in. What am I missing? Is this idea wise? If not why?
photo credit: db photographs
The proposed scenario could work but it does involve significant additional risks.
Does the 100% employer match immediately vest? How stable is the employer? How long should the son/employee rely on the employer’s generous 100% match? Does the employer impose any penalties for early withdrawal of matched retirement contributions?
I assume the son/employee will invest the 401(k) contributions in securities (stocks, bonds, etc.). How many years is the money invested in the market? If the goal is to start graduate school in less than five – ten years, why take the risk of another market tumble? What level of loss is the son/employee willing to suffer in the market? How much loss offsets the employer’s match considering the taxes and 10% penalty?
Sure, everything could go as planned and this path would seem to provide a better return.
Alternatively, the student loan interest rates are known. Paying down 7% interest provides the same level of return. Where else are you going to get a guaranteed 7% return on your investment? Paying down the debt isn’t attractive, doesn’t make for a cool story to tell your friends. It is boring but effective.
Finally, consider the costs of graduate school. Can the son go to graduate school without incurring additional debt?
I hope this helps. I wish the son the best in his plan, no matter which path he takes. Hopefully he has learned to sit down and consider all of the costs before moving forward with his course of action.
Cedric
Of course this is not legal or financial advice. I am not aware of any additional information. Seek the counsel of a professional.
Cedric,
Thanks for taking time to point out several possible downsides of this plan. I will make sure my friend reads this because I don’t know the answer to whether the employer match is immediately vested or whether the employer would impose penalties for early withdrawal of matched contributions. I would think these two factors are vital.
About the investment itself – because it is going to be short term, I recommended putting his 401k into whatever option is most conservative; even a savings account if possible. The idea is not to try to make anything from the market, but to take advantage of the employer’s match.
The son would love to go to graduate school debt free and I understand that he would use the 401k for that purpose.
Thanks again for putting some thought into this. It is just what I was hoping for.
Joe, I’m with you. I go with the conventional wisdom that retirement plans are for, well….retirement. If you spend retirement money, you don’t get a second chance to invest for the long term.