Moving money to and from retirement accounts like a 401(k) and a Roth IRA can have a considerable impact on your monthly student loan payments if you are a federal borrower.
Many federal borrowers depend upon income-driven repayment plans like IBR, PAYE, or REPAYE to keep their monthly payments affordable. On IDR plans, payments are based on what borrowers can afford rather than what they owe.
The way the government calculates what a borrower can afford has some strange consequences for those saving for retirement.
Some retirement maneuvering can actually result in lower student loans and more student debt forgiveness. Other retirement planning strategies may cause larger student loan payments, even though the borrower moves money from one retirement account to another.
Today, I’ll break down how the government calculates monthly payments and how your retirement planning can influence monthly payments.
Defining Income for Income-Driven Repayment Plans
The critical number for borrowers to watch is their Adjusted Gross Income (AGI) from their most recent tax return. As AGI goes up or down, monthly student loan payments go up or down.
AGI is an all-important number because it is the starting point for discretionary income calculations. The Department of Education calculates discretionary income and then charges borrowers a percent of that number each month. The higher your AGI, the higher your discretionary income, and the higher your monthly payments.
As borrowers, we have a huge incentive to keep our AGI as low as possible during tax season. A lower AGI means a lower tax bill and lower student loan payments.
Retirement plan contributions, conversions, and withdrawals can have a huge impact on AGI.
In a Roth conversion, a taxpayer moves money from a retirement account like a 401(k) or traditional IRA and puts it in a Roth IRA. There are many circumstances where a Roth conversion is a sound retirement planning strategy.
However, the downside to a Roth conversion is that Uncle Sam charges taxes on the money that moves into the Roth account. The year you transfer money from a traditional IRA or 401(k) into a Roth account, it will raise your AGI.
In other words, a Roth conversion can mean larger student loan payments.
From the borrower’s perspective, this seems unfair. Moving money from one retirement account to another doesn’t mean you have extra money to pay toward your student loans. Unfortuantely, the discretionary income calculation is a blunt instrument, and anything that raises your AGI raises your student loan payment.
Sherpa Tip: A Roth conversion isn’t always a bad idea if you have federal student loans. However, you should consider the increased monthly payment as one of the potential downsides of the conversion.
401(k) and IRA Rollovers
Moving money from a 401(k) into an IRA is a common retirement planning move. If you change employers, moving the money from an old 401(k) account is often a really smart move.
For student loan borrowers, a traditional IRA rollover is harmless.
When the money goes from the 401(k) of your old workplace into your traditional IRA, there are no tax consequences. No tax consequences mean no changes to your AGI and no impact on your monthly student loan payments.
What is the difference between an IRA Rollover and a Roth Conversion?
Traditional IRAs and 401(k) are tax-deferred accounts, meaning the money goes into the account without paying income tax. You don’t have to pay taxes until it comes out.
In a Roth account, you pay taxes on the money before it goes in, but withdrawals during retirement are tax-free.
Thus, if you move money from one tax-deferred account to another, there is no tax bill, but if you move from a tax-deferred account to a Roth account, you have to pay taxes on the money that moves.
401(k) and IRA Withdrawals
Pulling money out of a 401(k) or traditional IRA before retirement is expensive. In addition to the regular taxes that apply, a 10% early withdrawal penalty may also apply.
Because of the high cost associated with an early withdrawal, this move typically only happens if someone is facing a major financial emergency, they make a mistake, or they qualify for a penalty-free withdrawal.
Regardless of the circumstances that lead to the withdrawal, it is bad news for student loan borrowers. Money that comes out of a 401(k) or traditional IRA increases your AGI. Thus, whether you are retired or in a financial crisis, withdrawals can increase student loan payments.
The flipside of this equation is retirement plan contributions.
If you put money in a tax-deferred account like a 401(k) or traditional IRA, it lowers your tax liability. These contributions lower your AGI and lower student loan payments for borrowers on IDR repayment plans.
Not everyone can afford to make retirement contributions, but if you can swing it, the advantages are huge. Setting aside money for retirement means:
- a lower tax bill
- lower IDR payments for a year
- more debt is forgiven if you reach forgiveness
This strategy is my favorite way to eliminate student debt and save for retirement.
Final Thoughts on Roth IRA Conversions, 401(k) Withdrawals, and IRA Conversions
Up to this point, we have only looked at the student loan consequences of these moves.
A Roth IRA conversion isn’t always a bad idea for student loan borrowers. Similarly, your finances may necessitate an early withdrawal from a 401(k).
The planning behind any retirement account maneuvering should go far beyond the student loan impact. However, the student loan consequences should undoubtedly be a factor in your decision.