Q. I am a social worker and don’t make much money, but I think that will change after I get my graduate degree. I plan to continue to work and get my graduate degree through night courses over the next three years. I’m very good at math and already have a position lined up as an actuary once I graduate; the salary will be sweet. I’ve been reading your columns for years and ever since I was 16, my parents have been adamant that whenever I received a monetary gift I would give 10 percent to help others, save 40 percent and I could spend the rest. Your columns and my parents’ guidance may be why at the age of 27 I have over $15,000 invested in a no-load mutual fund within a Roth IRA, $20,000 in my 401(k) and $13,000 saved for a down payment on a small condo. My annualized rate of return on my Roth and 401(k) is about 16 percent and 12 percent, respectively. I know that’s not a lot of money, but it’s more than any of my friends have saved. My annual graduate cost will be about $20,000. Here are my questions: Should I raid my Roth IRA and/or lower the amount I put into my Roth IRA and 401(k) to put that money toward my education or continue to save for retirement and take out the maximum I can in subsidized and unsubsidized Stafford loans?
A. Thirty-five thousand dollars$35,000 saved for retirement and $13,000 saved for a down payment at age 27 is very impressive, even if your income was high but especially on a low income! Stafford loans for graduate degrees are all unsubsidized, so all interest will be charged during in-school, deferment and grace periods. You will be responsible for interest from the time of disbursement until the loan is paid in full. You can choose to pay as you go or defer the interest and have it added to your capital, which will increase the amount you will need to repay. Currently, there is an origination fee of 1.072 percent and a fixed interest rate of 5.41 percent for graduate Stafford loans with a maximum loan amount of $20,500 for most degrees.
If you are pretty sure that you will be earning a good salary in your new career, I’m leaning toward loans to fund your education. I hate to see you raid your retirement funds, especially if they are in good-performing, low-cost mutual funds. I know there is no guarantee that you will continue to have double-digit investment returns, but at your young age you can afford to deal with the ups and downs of the market. If you plan to continue working while taking courses, you should be able to meet your living expenses and pay for school with Stafford loans. Once you start earning that “sweet” salary, making your student loan payments probably won’t have much of an impact on your lifestyle.
If, as you stated, your current income is low and you are not able to fully fund both your Roth IRA and your 401(k) plan, you should fund your Roth IRA first for at least three reasons. If you are in a low tax bracket, the tax deduction provided by the 401(k) contributions is not that great. The Roth IRA doesn’t provide any current tax savings, but with your dedicated approach to savings, I would be surprised if you are not in a higher tax bracket once in retirement. Being able to take money from your Roth IRA tax free in retirement or leaving it for your heirs will be advantageous over the small tax deduction derived from the 401(k) contribution. As your income rises, there will be a time in the future when you will not be able to contribute to a Roth IRA due to the income limitation.
If you fully fund your Roth IRA for the next three years and then due to income limitations are unable to make any more contributions, assuming an annualized 8 percent rate of return, when you’re 60 your Roth will be worth $369,802. If you leave your 401(k) untouched and make no more contributions assuming the same rate of return, when you’re 60 it will worth $253,520. Good luck with graduate school and your new career.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624