I’m 33 years old and have $24,000 in federal student loan debt with a 6.8 percent interest rate. Would it be a smart idea to utilize the CARES Act to access my Roth IRA penalty-free and use the money to pay my student loans off in full? I have somewhere around $55,000 in my IRA. I could really benefit from not paying these loans every month, but I don’t know if it is a good financial decision.
– Pat A. in Ohio
Howard Dvorkin, CPA and Debt.com chairman responds…
Without studying your Roth IRA in detail, I can’t advise you for certain – but you probably shouldn’t raid your IRA to pay off your student loans.
I’ll explain why in a moment, but first you need to know this: It’s not just a financial decision. It’s also a psychological one. Let’s start with the numbers first.
Earnings vs. cost
Interest rates taketh away, but they also giveth. We already know you’re paying 6.8 percent interest on your student loans. What interest are you earning on your Roth IRA investments? Historically, those bring average annual returns of 7 to 10 percent.
If you’re earning more than you’re paying, it makes no sense to deplete your Roth IRA. Even if it works out to be exactly the same, there’s another number to consider. It has to do with your tax burden.
Taxes vs. freedom
The most attractive feature of a Roth IRA is how it deals with income taxes. A traditional IRA lets you contribute to your retirement without paying any taxes up front. That means you have more money earning more return up until you retire. When you withdraw money from a traditional IRA, you’re hit with a big tax bill.
A Roth IRA does it backward. You pay taxes up front, but not when you withdraw the money many years later. There are pros and cons to both, but a Roth IRA is a better option if you believe your taxes will be higher when you retire than they are right now. That’s usually true for a couple of reasons I won’t delve into here, but suffice to say, it’s a real nice bonus to know whatever you see in your Roth IRA is all yours, and none of it goes to Uncle Sam.
Taxes also play a big part in the CARES Act’s rules about retirement funds. While it waives fees and penalties for withdrawing from your retirement, it doesn’t stop the tax penalties that result from those withdrawals. Here’s what the federal government says…
While the Act protects you from the 10 percent early distribution penalty, it does not exempt the withdrawn amount from taxes. The amount will be added to your annual income and taxed as such.
So you need to factor in these costs, too.
Intentions vs. reality
At this point, I know what you’re probably thinking, Pat: “Sure, I know it’s better to keep my Roth IRA than cash it out, but I’ll put it all back right away!”
I know you believe that right now. The problem is, most people don’t.
One study showed “44 percent of those who have borrowed against their retirement plan savings regret the decision” – and that was before the pandemic. Why the remorse? Because various retirement vehicles have fees for taking out the money, deadlines for putting the money back, and penalties if you break those deadlines.
Roth IRAs are a little different, because you paid your taxes up front, and the CARES Act makes it easier to raid many retirement funds to get past this current crisis. However, Pat’s question isn’t one of financial survival. It’s not, “Do I not pay my bills or do I withdraw some retirement money so I can survive today?”
Since you’re simply trying to save some interest, it’s a smart question. It just might not be the smart move – because even if you can save thousands of dollars right now on student loans, what happens next?
In my experience, once someone gets out from under an oppressive debt like student loans, there’s no guarantee that an individual saves the same amount they were paying to their lender. Often, they simply spend that same sum on themselves.
So I worry about you, Pat. If the Roth IRA is used to pay off those student loans, will you up the contribution to your Roth IRA? Or is there a hot new luxury car in your future?
I’d like to think you’ll do the right thing, Pat, because you’re asking the right question right now. I’m just issuing two warnings: Do the math first, then peer inside your own mind.
