LAST REVIEWED Dec 16 2020 11 MIN READ
By The Human Interest Team
In the not-so-distant past, accepted wisdom was that if you had student loan debt, you paid it off before contributing to a retirement plan. This is now changing, thanks to new programs from a few of America’s largest corporations and guidance from the IRS.
Student loan debt and financial wellness
College graduates without student loan debt are in a lucky place. They tend to have better financial outcomes than those who carry student debt, including the ability to get ahead in their retirement savings. A study by the Center for Retirement Research at Boston College found that those with student loans have 50% lower balances saved for retirement than those without student loans. What’s surprising is that the amount of debt doesn’t matter. Graduates who owe relatively small or large amounts seem equally hindered in saving for retirement.
Employer-matching 401(k) contributions for employees making student loan payments
Abbott Laboratories had this novel idea: since their employees with student loan debt generally don’t contribute to the company 401(k) program, the company contributes on their behalf while they’re paying down their debt.
How does Abbott’s program work?
In Abbott’s Freedom 2 Save program, the health care conglomerate contributes 5% of employees’ gross salaries to its 401(k) plan if they use 2% of their income to pay down student loans through a payroll deduction. This policy is similar to the company’s default policy for employees without student loans, which is a 5% match for those who contribute at least 2% of gross pay to the company’s 401(k). The program is available to both part-time and full-time employees who are eligible for the company’s 401(k).
To make sure Uncle Sam was on board with its idea, Abbott asked the IRS for clarification through a formal Private Letter Ruling (PLR). A PLR is a written statement from America’s tax collection agency on the legal implications of an unusual situation. In PLR 201833012, the IRS authorized Abbott’s program.
Currently, employers are allowed to make matching contributions to a 401(k) when employees make contributions to the plan. However, a PLR isn’t a law, so some senators and representatives on Capitol Hill are now hard at work trying to codify the student loan-401(k) scheme into a new statute. If that happens, it could change the benefits landscape for the 43 million Americans who carry student debt.
How is this different than a student loan repayment benefit?
With a student loan repayment plan, dollars are given directly to employees. Therefore, those amounts are treated as taxable income. The major difference in the student loan-401(k) scheme is that the employer contributions are not taxable. Therefore, leveraging this new type of plan can help employees achieve tax advantages, similar to those associated with traditional tuition-reimbursement benefits but are generally not accessible for employees enrolled in a student loan repayment benefit.
The student debt crisis is becoming a retirement crisis
The challenge of balancing paying off debt vs. saving for retirement is a question that college grads have faced for decades. Facing that dilemma isn’t what anyone wants to have last for decades. Unfortunately, for many it is. Americans near and in retirement age are the fastest-growing demographic with student loan debt. What’s encouraging is that President-Elect Biden is proposing to implement some measure of student loan forgiveness, which has the potential to make a huge difference. For example, the average monthly student loan payment is $393. If instead of putting that money towards a loan, a 30-year-old is able to invest that monthly amount for retirement, they could end up with a nest egg of more than $428,000, assuming a 5% return. Comment end
*In this example, an individual begins investing $393 on a monthly basis for 35 years, and receives a 5% rate of return (assumes annual compounding).
More legislation to watch: S.1431
In the Senate, S.1431 (the Retirement Security and Savings Act of 2019) is making its way through the necessary channels before being reconciled with similar bills circulating through the House. The Senate bill would permit employer matching contributions based on student loan payments, as if the payments were retirement plan contributions. The Retirement Parity for Student Loans Act (S.1428), which has also been introduced, attempts to do the same thing.
S.1431 would also permit rollovers into a Roth 401(k) from a Roth IRA, something that’s not currently permissible. Other proposed changes include pushing the required minimum distribution point from 70½ years of age to 75, the creation of multi-employer 401(k)s, and the establishment of lifetime income estimates for plan participants.
The catch-22: Should I pay off debt or contribute to my 401(k)?
Most companies don’t yet offer the student loan 401(k) contribution. And, student loans aren’t the only form of debt. Many Americans have auto loans, credit card balances, and mortgages that could be paid down with funds otherwise going into a nest egg. If you have any of those sorts of debts, it’s a trade-off between saving for retirement and eliminating debt that charges interest.
The rule of thumb to follow here is to pay down debt that charges interest higher than the expected return on your 401(k). According to CNBC, the annualized total return on the S&P 500 index over the past nine decades is almost 10%. Total return means that dividends are added to the rise in stock prices. Any debt that has an APR higher than the expected return of the S&P 500 should be a prime candidate for paying off. If that means cutting back on 401(k) contributions, then so be it.
Develop a projected 401(k) return
Choosing between contributing to a 401(k) and paying down debt is part science and part art. For example, the return on investments held in the S&P 500 is an average, which may or may not continue, and which probably won’t be replicated by a fund or stock with different risk-return characteristics. In other words, because an expected rate of return is an estimate based on historical data, there’s no way of knowing for sure if a particular debt’s APR will in fact be higher than an investment’s return.
It’s important to develop a projected return for each individual account based on its underlying holdings because not every 401(k) invests in the S&P 500. Small-cap or sector funds may be able to outperform the S&P over the long run (though they may be more volatile, too). On the other hand, funds that invest primarily in fixed-income instruments could underperform the index over several years or more.
With any investment strategy, debt that charges interest higher than the expected return of the account typically should be paid down with whatever funds are available. That means that credit cards are the first that need to be paid off since these accounts usually charge higher rates of interest than other loans.
The idea is to start with accounts that charge above-average rates of interest and gradually move down to lower rates. Average credit card rates currently range in the upper teens, from 14% to 19%. Payday loans charge even higher rates. If you’re carrying any balances at these rates, you definitely should pay them off before contributing to a retirement account.
Unless you shouldn’t. The one exception is when you can get an employer match for your contributions. With either a 50% or 100% match, you receive an immediate 50% or 100% return on your investment, which exceeds virtually all loan rates today. But you shouldn’t contribute more than the minimum necessary to capture matching contributions. Learn more about different employer match types here.
Debt can be managed; failing to save for retirement can’t
Remember that it’s possible to manage debt over time. But if you miss out on saving for retirement, you may end up with a problem that can’t be solved. There are loans for many of the big-ticket items we purchase in life, but there aren’t any loans to finance your retirement. Make sure you capture those employer contributions as soon as you can.
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The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.