Many parents may not have been able to help their children fund college while their kids were in school, but as these parents approach retirement, they get a second chance to help pay for school in the form of student loan repayment assistance.
One such parent recently emailed us the following question:
I’m interested in making annual lump sum payments on my daughter’s student loans, using one of my retirement accounts from which I can withdraw without penalty. Have you heard of this being done, and can you advise me on the effects it might have on a repayment plan? The end goal is to pay the student loans ($60K) off in about five years so that I don’t incur an excessive income jump in any one year.
While helping children out with their student loan payments may sound like a simple and straightforward process, several factors require consideration.
Don’t Ruin Retirement
We’ve already discussed the dangers faced by parents who sacrifice their retirement to help their children pay for school. The same concerns apply to parents who wish to help out their kids pay off their student loans. Offering assistance is admirable, but be careful not to stretch too thin. The last thing any parent or child wants is to have student loan assistance be the cause of a retirement plan failing. Before making any student loan contributions, it is essential first to make sure the payments are affordable.
Think About the Payment Consequences
Many individuals repaying their student loans have multiple loans and/or multiple lenders. When facing this situation, targeting the best loan to pay down is a critical consideration.
Parents choosing to help by making a large student loan payment should carefully consider how the payment is applied.
For those making a lump sum payment, one strategy would be to pay off a loan entirely. By eliminating a single loan, you free your child of a monthly student loan bill. If the payment only covers part of the debt, the monthly student loan bill will remain the same.
Another option is to pay down the student loan with the highest interest rate. This approach won’t free up cash each month for your child, but it will help them eliminate their debt the fastest.
Finally, most borrowers should pay off private loans before paying off federal student loans. Federal student loans come with borrower protections like income-driven repayment plans and student loan forgiveness. Because of these federal programs, paying off the more dangerous and less forgiving private loans is usually the best plan.
Lump-Sum vs. Monthly Payments
Making lump-sum payments is typically more productive than sending out monthly payments. This is because of the daily accrual of interest on the debt. The larger the payment, the less interest can accrue. From an accounting perspective, making a lump sum payment will get your child to student debt elimination the fastest.
The advantage of monthly payments is that you can take over the monthly burden from your child. It becomes one less bill for them to worry about for as long as you cover the payments.
Don’t Forget Taxes
The approach suggested by the reader email — spreading out the lump sum payments over several years — is a brilliant move. This allows the 401(k) withdrawals to be taxed substantially less. Because 401(k) withdrawals count as income, it is vital to ensure that your yearly income does not become too high and subjected to a larger tax rate.
With the passage of the 2018 tax bill, there are two large jumps that many parents might face. The first is from the 12% bracket to the 22% bracket, and the second is from the 24% bracket to the 32% bracket. If you are near one of these big jumps in the tax rate, it will be important to discuss your plan with your tax preparer so that you can stay within the desired bracket.
Finally, for children with substantial balances, gift taxes may come into play. The good news is that families can usually avoid the gift tax, as discussed in a previous article on gift taxes.
Taxes vs. Interest
One way to look at student loan assistance planning is to weigh the tax vs. interest consequences. If you make a large withdrawal from your 401(k) and pay off the student loans completely, you will save your child the maximum amount in interest possible. However, you will also maximize your tax costs.
If you spread out the contributions over many years, the tax burden shrinks. However, that means more spent on student loan interest over the life of the loan(s).
The key is to find a balance between these two competing issues. Interest rates and individual marginal tax rates will mean the optimal approach varies from one family to the next.
An Additional Trick
Parents looking to assist their children might also consider facilitating a student loan refinance by consigning a refinanced student loan. We usually don’t recommend cosigning, but if you plan on paying off the loans and won’t be making a housing purchase or other large purchase over the life of the loan, it might make sense. This could allow for lower interest rates and spreading out the lump sums over the years.
This route is effective because lenders consider cosigned loans to be less risky. By having less risk, lenders can charge a lower interest rate. Our student loan refinancing page has a list of lenders providing this service, a more detailed explanation of how it works, and some tips for getting the most out of the process.
Student Loan Payment Help from Parents Can Take Many Forms
Every family will be looking at different student loan situations and tax considerations. What works best for one family may not be the best option for another. The key is to think about different strategies to see how the numbers play out.
If my daughter is paying on her student loans using one of the income-based repayment plans, can I separately make extra payments on those loans from time to time or even regularly without adversely affecting her repayment plan option?
there is nothing wrong with paying extra… one reason you wouldn’t want to pay extra is if your daughter is working towards student loan forgiveness
What is the difference if she is working toward forgiveness? Don’t both payer and repayee involve forgiveness? Or are you referring to PSLF? Still, why does that matter?
If her debt elimination plan is to use student loan forgiveness, such as PSLF, paying extra won’t help anything. The forgiveness programs look at how many payments were made… not the amount paid.
That all being said, if she will eventually be paying the loan off in full (which is the case for most borrowers) paying extra will be very helpful to her and it will not affect her repayment plan options.
When looking to refinance a private student loan is the existing student loan debt considered in your debt to income ratio?
Lenders don’t really reveal the exact factors that go into their calculations, but my educated guess would be that loans to be refinanced are not included, but existing student loans that are not in the refinance would be included.