Robbing 401(k)s to Pay Student Loans Is Tiny Tweak to Big Problem

(Bloomberg Opinion) -- Rand Paul should have seen this coming.

The Republican senator from Kentucky last week unveiled the Higher Education Loan Repayment and Enhanced Retirement Act, or “Helper.” Most notably, it would allow individuals to withdraw up to $5,250 a year from their 401(k) plans or IRAs — tax- and penalty-free — to cover college costs or pay off student-loan debt. The thought process, I gather, is that it would create a stronger incentive to plow as much money as possible into 401(k) accounts, with their tax advantages and typical company-match policies. That, in turn, would serve to chip away at both the U.S. retirement crisis and burdensome student loans in one fell swoop. A win-win.

Of course, the reaction to the plan was precisely the opposite. The immediate outcry (his tweet has the dreaded “ratio” of significantly more comments than likes) was that his bill actually presented a lose-lose situation, doing little more than “rob Peter to pay Paul.” Many young people weighed down with student loans may not have extra money sloshing around in retirement funds, meaning the proposal would largely benefit the highest-earning college graduates or parents.

“We think it’s important for Republicans to have a solution to the problem,” Paul said, according to the Associated Press. “Democrats have come forward with something that we think is well-intended but fiscally irresponsible.”

The Helper Act is not a broad “solution,” by any stretch of the word. It’s simply too narrowly focused to truly tackle the $1.5 trillion of student-loan debt outstanding, and its knock-on effects on everything from home ownership to birth rates. It also does nothing to address the underlying problem — namely, that college tuition and fees have increased by four times the pace of overall U.S. inflation over the past three decades.

But it also doesn’t necessarily make these problems worse, either. Ultimately, it’s just small potatoes.

To judge Paul’s proposal, it’s worth stepping back and looking at the Millennial balance sheet. Federal Reserve data show that more than 42% of the cohort has retirement accounts, which is the second-largest share of the past 30 years for Americans under age 35. The mean value rose to $32,500 as of 2016, which is nearly the most-funded on record. A 2019 Fidelity Investments study found millennial participation in 401(k)-type plans increased by 82% in the past 10 years. So it’s not quite accurate to say that young people as a whole aren’t saving for retirement.

Of course, the flip side is that about 45% of Americans under 35 had education debt as of 2016, with a mean value of $33,000. Both of those are record highs. Those liability figures are nearly identical to the statistics on retirement assets.

The question, then, is how much overlap exists between those who have retirement accounts and those who have student loans? A reasonable hypothesis would be that those with college debt are putting their extra income toward paying it down. The current fixed interest rates on federal loans are 4.53% for undergraduates and 6.08% for those attending graduate school, according to the Education Department. It usually makes financial sense to chip away at the principal amount rather than bank on market returns, though the calculus partly depends on the employer’s 401(k) match. 

Paul seems to be targeting parents of college students just as much with his plan; in that context, it makes more sense. Saving for a child’s education is a big deal for many families, and there are already tax-advantaged options like 529 plans. Helper would just layer on top of that the ability to use pre-tax money (529s are funded with after-tax contributions) that has been growing for decades thanks to a combination of market gains and employer matching.

And yet, the press release announcing the bill used a somewhat strange example:  

“The plan would enable two parents and a child, for example, to put over $15,000 in pre-tax funds in one year toward tuition or loan repayment if each set aside the maximum. Currently, Americans can only pay for their student loans with after-tax money, placing an unnecessary constraint on their budget.”

Maybe some families would do this. But it’s difficult to envision a scenario in which a large number of current college students are plucking $5,250 from their 401(k) plans or IRAs each year. I suppose it’s less of a reach to consider parents dipping into their pre-tax retirement accounts to help their adult child pay down loans, but that still feels like an awkward arrangement. 

It all feels like a piece of legislation trying to do too much. Around this time last year, I drew the same conclusion about a bill that would tie much-needed infrastructure spending to funding pension plans. Both are noble causes, but it’s just too cumbersome to fix interest rates on 40-year bonds, market them only to pension managers, and then mandate that they hold the debt for 10 years. Tackle one crisis at a time.

The same goes for Paul’s student-loan plan. Why must the funds be funneled through a retirement account? Wouldn’t it be easier to make it so graduates can select a percentage of their pre-tax income to put toward student-loan payments, as they do now with 401(k) plans? Paul touts that many employers match 401(k) contributions, but they’re already starting to do the same with student loans, too.

And why stop at $5,250? Paul is all for lower taxes, and Moody’s Investors Service has said canceling student-loan debt, as Democratic presidential contenders Bernie Sanders and Elizabeth Warren have proposed, would “yield a tax-cut-like stimulus to economic activity.” Paying off student loans entirely with pre-tax dollars would also wind up putting more money in Americans’ pockets. 

To be sure, even these tweaks would benefit high earners the most. Mark Zandi, chief economist at Moody's Analytics, said he doesn’t expect Paul’s legislation to provide “any meaningful relief to distressed student loan borrowers.” And those ranks are growing: Defaulted student loans make up 35% of the $250 billion of debt the New York Fed considers “severely derogatory,” a larger share than mortgages, credit cards or auto loans. 

Something must be done to reverse this trend. Paul, to his credit, recognizes that, and this plan seems to be his attempt to steer the student-loan conversation away from “forgiveness or bust.”

Unfortunately, the proposed legislation falls short in several ways. Most notably by doing nothing about digging into the root cause of the student-debt boom: college affordability. Paul’s plan would merely chop down a few branches.

Also part of Paul's plan: Employer-sponsored student loan and tuition plans would be tax-free, up to the same $5,250 limit annually.

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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