Mailbag: Marriage, IBR, 401(k)s, and long-term planning

Michael Lux Blog, Lower Payments, Mailbag, Student Loans 1 Comment

Yesterday I received a very well thought out email from a reader who recently got married.  He doesn’t have student loans, but his new wife has over 100k worth.  In their favor is the fact that they have a 401(k) with more than enough money to pay off all the debt, an investment account, and two jobs with a good income.  They are trying to figure out how to handle their student loans for their 2014 taxes and in the long-term.  Prior to their marriage, the wife’s plan was to just make payments under the IBR plan, and have the rest of the debt forgiven after 25 years.  They want to know how their recent marriage should affect things.

What makes this question excellent is that it forces us to take a look at how a number of student loan issues converge.  We have already covered in great depth the considerations of paying off student loans vs. saving for retirement.  Similarly, we covered the pros and cons of filing jointly vs. filing separately.  Add some long term income based repayment planning into the equation and things can get pretty complicated very quickly.

In order to discuss this question, we need to make a couple of assumptions.  The first is that we are going to do what is best for the couple, rather than the husband or wife.  In other words, we are not going to get into the family law issues that could potentially arise.  We are also going to assume that the interest rates in play stay reasonable.  That means no student loans with absurd credit card level rates, and no investment opportunities with huge guaranteed returns.

Finally, it is worth pointing out that there really isn’t a right answer or even an easy answer.  We will cover how these issues come together and go over some of the considerations.  Ultimately, it will come down to personal preferences such as debt aversion vs aggressive investing and some old fashion math.

First Consideration: Federal vs. Private Loans

Nearly all student loan planning starts with separating loans into these two groups.  Federal loans have certain benefits such as income based repayment plans and loan forgiveness, while private loans will almost always have to be paid back in full.  Federal loans normally have decent but not great interest rates, and private loans can have amazing interest rates – from amazingly low to amazingly high.  Because the private loans don’t have the protections associated with the federal loans, we normally recommend that they get paid off first.

Second Consideration: Aggressive Payoff vs. Targeting Forgiveness

Trying to get student loans forgiven seems like a no-brainer.  Even if it is just a few bucks forgiven, having the government foot the bill for your education seems great.  Unfortunately, it really isn’t that simple.  Standard loan forgiveness under the IBR plan takes 25 years.  If you are only paying the minimum, over that long length of time, chances are that you will be spending a ton on interest.  Worse yet, when your loans are actually forgiven in the future, the canceled debt is treated like income for tax purposes.  Add the extra interest payments and the big tax bill and the savings isn’t nearly as big.  In fact, it could cost more in the long run.  This is one of those cases where you need to do some math.  Guessing your salary over the next 25 years is tricky, so run through the calculations a few times.  Try once with some pessimistic future earnings projections, and then try some more optimistic ones.  This range of outcomes can help shed some light on the best approach.

Another concern associated with planning on forgiveness is the danger of an act of Congress messing everything up.  Congress could rewrite student loan laws in a plan to fix student debt and it could make forgiveness programs far more attractive.  On the other hand, they could change things to make forgiveness less attractive or even eliminate the program.

Third Consideration: Retirement Funds vs. Eliminating Debt

For starters, the retirement funds that you use could shift the math greatly.  If you have an investment account that you can liquidate quickly, things are pretty easy.  However, if your money is in a 401(k), any planning has to account for penalties that you will incur should you decide to withdraw the money.

This question really comes down to risk aversion.  It is possible your investment could perform better than the interest rate on your student loans, meaning it is best to not pay them off immediately.  However, it is also possible that your investments do worse, making it better to have paid off your student loans first.

Fourth Consideration: Private Consolidation Options

With a number of private student loan consolidation companies offering very low interest rates, the math can get even more fuzzy when you factor in this opportunity.  If you can get your high interest rates lowered to 3% or lower, keeping your money invested and growing might be the best option.  However, this option also has risks.  If you consolidate your federal loans into a private consolidation loan, you lose the government perks.  This alone can be a tough decision to make.

One thing that should be avoided if you decide to go this route would be co-signing loans.  If just the Mrs. is on the loan, you really don’t want to create a new loan with two names on it.  Co-signing for these loans can make home purchases and auto purchases more difficult.

Fifth Consideration: Filing Jointly vs. Separately

Filing separately lowers your IBR payments and it makes student loan forgiveness a more valuable perk.  However, it also means that each April you will owe more in taxes.

If you are doing the forgiveness math, it means you need to compare the expected amount forgiven against the total interest paid, additional taxes from the loans being forgiven, and the additional taxes each year from filing separately.  There are lots of variables and some projections/best guesses that have to be made, but in this case you can at least look at both sides of the equation.

How does it all come together?

There are many variables to consider.  To make the most informed decision, go through a bunch of what-ifs.  Go through the math if one of you is out of work for a year.  If kids are a possibility, run the math factoring in a bundle of joy or two.  Try doing a couple projections assuming your investments perform well, average, and poorly.  As you go through each option, weigh the risk vs. reward for each choice you could make.

Keep in mind that some decisions are more permanent than others.  You could keep things in the status quo and reevaluate things next year.  However, if you empty out the 401(k) to knock out the debt, you can’t really undue that choice.  Regardless of which route you choose, have a plan to evaluate your options as time goes on.

There really isn’t a simple equation or a simple answer.  When things get this complex, the best things you can do for yourself are an honest assessment of what you need, want, and can afford.  The more time and consideration you give your decision, the better off you will be.