Barry’s Pickings: Borrowing to Save

Michael Barry, president of October Three (O3) Plan Advisory Services LLC, provides the math for why it makes sense to pay off debt before saving for retirement.

In the last couple of months several bills have been introduced in Congress designed to incentivize savings, including (especially) short-term savings. Perhaps the main concern this legislation seeks to address is the fact that (as the Federal reserve reported in its Report on the Economic Well-Being of U.S. Households in 2017 (May 2018)) “Four in 10 adults in 2017 would either borrow, sell something, or not be able to pay if faced with a $400 emergency expense.”


The hook to retirement policy is that plan participants facing this sort of emergency expense are likely to raid their retirement savings to deal with it, thus compromising retirement security. Solution: use defaults and (perhaps) tax incentives to encourage more short-term savings.


Let’s review some facts.


The Federal Reserve Board’s 2016 triennial Survey of Consumer Finances (SCF) found that 43.9% of American families held credit card debt. For those holding this debt, the median balance was $2,300, and the average was $5,700. More than two in ten (22.4%) are carrying student loans, with a median balance of $16,500 and an average balance of $34,200.


According to the St. Louis Fed, the average credit card interest rate was 14.4% as of May 1, 2018. The rate on student loans is considerably lower, benefiting (among other things) from explicit and implicit federal subsidies.


Most experts expect returns on retirement investments to be in the mid to low single digits.


Joint filers who make less than $77,200 in taxable income pay no taxes on investment earnings. Unless their income tax rate in retirement is lower than their current income tax rate, these individuals will get no tax benefit from “regular” (non-Roth) 401(k) savings.


PLANSPONSOR recently reported on a TIAA Institute survey that found that “among households under the age of 55, each dollar contributed to a 401(k) plan or similar tax-advantaged retirement account is offset by approximately 40 cents in pre-retirement taxable withdrawals.”


There is a 10% penalty tax on these sorts of “early” withdrawals. We don’t have good data on how much the Internal Revenue Service (IRS) collects in these penalty taxes, but a 2009 Government Accountability Office (GAO) report (401(k) Plans: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers’ Retirement Savings) stated that “more than 5 million tax filers paid $4.6 billion in early withdrawal penalties in tax year 2006.” What is that number for 2017—11 years later?


If you were one of the 43.9% of American families with (on average) $5,700 in credit card debt, you would not need a slide rule to figure out that it would be crazy for you to save in an IRA or retirement plan before you paid off your credit card. Unless someone—the federal government or your employer—were (literally) paying you to save. And then, you might well withdraw or borrow it out as soon as possible—the fate of 40% of the dollars contributed by participants younger than 55. Maybe to pay off some of your debt.


To get an idea just how weird this system is, consider a 401(k) safe harbor plan where the sponsor matches 100% of contributions up to 1% of pay and 50% of contributions between 1% and 6% of pay. A (cash strapped) employee who makes $50,000 a year scrapes together $3,000 in 401(k) contributions to “buy” a $1,750 match. Then—as soon as possible, because she needs the money—she withdraws it all in a hardship withdrawal, paying income tax on it and paying an additional 10% early withdrawal tax.


If she had not contributed to the plan, she would have $2,640 ($3,000 minus 12% in taxes). By contributing to the plan, she got (via matching contributions) $3,705 ($4,750 minus 22% in taxes), so she clears $1,065 (versus not contributing to the plan). But the transaction cost the employer $1,750. She would have been significantly better off if the employer had simply written her a check—with which she could have paid off some of her debt.


And to state the obvious: nothing about this transaction increases retirement security. The money (the sponsor match) is just washed through the retirement system so that it can be counted for nondiscrimination testing.


Assuming no tax effects—that is, assuming that the participant pays no investment taxes and isn’t shifting income to a lower tax-rate year—and ignoring the employer match, the algorithm here is very simple: If your interest rate on outstanding debt is more than your expected return on plan savings, it’s better to pay off the debt than to save.


That (simplistic) approach, however, ignores an important factor—risk. The return on paying down debt is (in effect) guaranteed. But a participant investing plan assets and hoping to earn more than the rate on Treasuries will have to take some risk. Financial economics advocates might argue that American workers should be assuming they will only earn around 3% on their plan investment and compare the interest they are paying on their debt to that rate.


By the way, if you think you can win the bet that your assets will earn more than the interest on your debt, you might want to become a trader—they make that sort of bet every day. Except that their cost of borrowing (aka leverage) is much lower than the typical low-income American family’s, they have much lower transaction costs, and they have much better market information.


The foregoing begs some really obvious questions: Do American workers understand any of this? Do policymakers? Why are we spending significant tax dollars trying to encourage savings by low-paid workers when they are (in effect) borrowing to pay the rent (or to fund a $400 emergency)? At the very least, shouldn’t all of the tax incentives for savings, most significantly (I would argue) Tax Code nondiscrimination testing, include an alternative incentive for paying down debt?


There are actually some companies that are trying to tackle the issue of education debt, making 401(k) matching contributions to the accounts of participants who pay down their student loans. Why aren’t we seeing more bills encouraging these designs? Indeed, why shouldn’t we be using defaults and tax incentives to support them?


Borrowing to save—isn’t that something that only an oxymoron would do?


Michael Barry is president of October Three (O3) Plan Advisory Services LLC. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly about retirement plan and policy issues.


This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.