Dear Liz: I have about $16,000 in student loans at 6.8% interest. At the current monthly payment it would take me about 7.5 years to pay them off. I contribute 10% of my income to my company's Roth 401(k) plan (my employer matches the first 6% contributed). I also contribute 3% to the stock purchasing plan. I am thinking of cutting back my 401(k) contribution to 6% and not contributing to the stock purchasing plan. Applying the extra money to my loans would reduce the payback period to about 2.5 years. After that, I would increase the contribution amount and diversify with a Roth IRA as well and maybe even begin the stock purchase program again. What do you think?
Answer: Not contributing to retirement accounts is usually an expensive mistake. The younger you are, the more expensive it can be.
Every $1,000 not contributed to a retirement plan in your 30s means about $10,000 less in retirement income. That assumes an average annual growth rate of 8%, which is the historical average for a stock-heavy portfolio.
In your 20s, the cost of not contributing that $1,000 is $20,000 of lost future retirement income. The extra decade of not getting those compounded returns makes a big difference.
People have the erroneous idea that they can put off retirement savings and somehow catch up later. Catching up, though, becomes increasingly difficult the longer you wait. A better approach is to save as much as possible starting in your 20s when the money has the longest time to grow. Then you'll be in a better position to withstand job losses or other interruptions of your ability to save. If those setbacks don't happen, you'd have the option of retiring early.
Granted, your plan would require reducing retirement contributions for just a few years. But the federal student loans you have are fixed-rate, tax-deductible debt that you don't need to be in a hurry to pay off. In the long run, you'd be much better off boosting your retirement contributions.
If you're determined to pay down your loans, however, use the money you've been contributing to the stock purchase plan. Continue making at least a 10% contribution to your retirement plan and increase that as soon as you can.
Paying for son's law school
Dear Liz: I have rental property, own my home outright, am contributing to a 401(k) and have a pension, so finances are not a big issue. I do have an adult son in law school and would like to know the most fiscally prudent way to pay for it. Are there limits on gifts, and can the money be tax deductible since it is an investment to increase his future earnings?
Answer: Interest on student loans is generally tax deductible for the person who takes out the loan if his or her income is below certain limits (the deduction begins to phase out at $50,000 adjusted gross income for single filers and $100,000 for joint filers), said Mark Luscombe, principal analyst for CCH Tax & Accounting North America.
Education tax credits also can help offset college costs. The American Opportunity Credit is limited to the first four years of college, but law school expenses could qualify for the Lifetime Learning Credit, Luscombe said. The credit starts to phase out at $53,000 of adjusted gross income for single filers and $107,000 for joint filers, he said.
If you don't qualify for other credits and your son is under age 24, you may be able to deduct up to $4,000 in qualified education expenses if your income is below certain limits (modified adjusted gross income of $160,000 if married filing jointly or $80,000 if single), Luscombe said. You can find out the details in IRS Publication 970, Tax Benefits for Education.
Another potential tax benefit has to do with the gift tax. You can avoid the hassle of filing a gift tax return, or using up any portion of your gift tax exclusion, if you pay tuition or medical bills for someone else. You have to pay the provider directly — you can't cut a check to the person receiving the services.
Normally, you'd have to file a gift tax return if you gave any recipient more than the gift tax exclusion limit, which is $14,000 in 2013. You wouldn't be subject to an actual gift tax, however, until the sum of the contributions over that $14,000 limit exceeded your lifetime gift exemption. The gift exemption is currently $5.25 million, so the gift tax is an issue that few people face.
If you are that rich and generous, then you'll probably want to discuss your situation with a qualified estate planning attorney to find the best ways to give.