Pay off Loans with 401k for ACA Subsidy

[mlipps]

My mom's company is discontinuing health insurance next year (under 50 employees). The currently qualify for a subsidy with an income around 263% of the poverty line. My parents are frugal and have done well for themselves on a low income their whole lives, despite not being terribly savvy about investing. They have a reasonable emergency fund, had about $120k in a 401k at the first of the year (I assume it's probably closer to $135k or so by now), and they owe about $20k on a small car loan and a home equity loan they took out for my college, both at very low interest rates.

My dad is about 5 years from taking retirement and they plan to have all the loans paid off by that time. I think they are probably paying $400-$500/month on them right now. With their income, they are well below the 15% tax bracket.

One idea my mom and I had when talking tonight is that perhaps they should take a distribution in 2013 from their 401k to pay off the loans. My dad is old enough to take the distribution penalty free, but will owe taxes. But, then they could increase their contributions for the next 5 years & increase their ACA subsidy.

After my dad retires, they plan to live primarily on his SS. My mom might continue to work a few years but she only makes minimum wage, so her income is around $14k/year working full time. The 401k will essentially serve as an emergency fund to replace their car when it dies eventually or replace the roof on the house, etc. So, I understand that they could be in a lower tax bracket upon retiring than they are now. The taxation of SS is a little fuzzy to me though, so I'm not exactly sure how to compare the scenario of paying the taxes now but then having a higher subsidy for 5 years versus the likelihood of lower taxes when taking a distribution in the future. Any input?

[klneutral]

I think you are on the right track to think real hard about the possibilities. It feels to me like there is fertile ground here.

I would gather all of the data, get a copy of 2012 TurboTax, or similar, and start running the numbers for all years between 2013 and the last year the youngest of your parents will eligible for ACA. Then I would play "What If" by juggling the numbers to see how it plays out. I would then take those results and put them into a spreadsheet and perform the analysis.

It sounds like one main problem is that your folks don't have the cash flow to increase their 410(k) deductions. Since part of their cash flow problem is paying off the loan related to your college education, is there any chance you could gift them some money to help them pay off this loan, allowing them to funnel more money to the 410(k)?

[mlipps]

I wish! I keep offering to pay the loans but my dad insists "You held up your end of the bargain, now we'll hold up ours." They're doing fine, not in dire straights, just breaking even every month. They know that I would chip in if they needed the help.

I did some more thinking about this and realized that the extra taxes in 2013 would be a wash because their taxes would be reduced by the same amount in the subsequent years when they would have been paying off the loans with that money. So, I think the amount that matters is the difference between the rate at which their money would grow if left in their 401k versus replacing on a monthly basis, less the interest they would save. The trouble of course is that it's very hard to predict what the future growth rate will be for their 401k over the next 5 years.

They're at a 40/60 AA right now, so I think 8% is a generous estimate, but who can really know? My math right now is that it would be pretty close to a wash at 8% interest, but if the market returned much less than that, they'd be better off taking the money out. If anyone sees flaws in my reasoning, I'd love to hear them.

[klneutral]

I thought the goal was to position your parents for an ACA subsidy.

If so, I can not stress enough the importance of doing the complete analysis, as I suggested previously. The magnitude of the subsidy may completely overwhelm any differences in taxes between different years as well as interest rate/growth considerations. In fact, that is the result I would expect in this particular case with low income.

This could be a pretty big deal for your parents. Since they are unwilling to take your monetary help, please do the work to try to save them some taxes to make their retirement a bit more comfortable.

[robertalpert]

How would a temporary increase in taxable income also improve or enhance their subsidy for ACA?

Taking a distribution in the 15% tax rate might not increase their taxes, unless the extra income pushes then to the 25% bracket. (I don't know much about tax laws --- or about ACA.)

Perhaps you / they should consult an accountant.

[robertalpert]

deleted due to editing error

[BrandonBogle]

How would a temporary increase in taxable income also improve or enhance their subsidy for ACA?

Taking a distribution in the 15% tax rate might not increase their taxes, unless the extra income pushes then to the 25% bracket. (I don't know much about tax laws --- or about ACA.)

Perhaps you / they should consult an accountant.

The point would be the distribution in this year, which does not count towards ACA subsidies, could be use to offset their expenses (either pay down immediately those loans or leave it liquid to augment their income over the next couple years) and then in subsequent years, they can increase their 401k contributions to reduce their income. This process would increase the ACA subsidy they get.

As others have mentioned, the devil is in the details and an analysis with tax software would be very worthwhile here.

[mlipps]

Yes, I think you're all correct that I need to do mock tax returns for the upcoming years. On their current income, my parents qualify for a 10% credit for retirement savings (Saver's Credit). I think in addition to increasing their future ACA subsidy, decreasing their income would bump them to the 20% or maybe even 50% level for the saver's credit in future years. Since they currently only contribute $2,000/year to my dad's 401k and the max for the Saver's credit is $2,000 per person, they could increase that tax credit in future years as well by contributing the funds to a TIRA in my mom's name.

There is also, in my opinion, a very high likelihood that my dad's company could follow suit in cancelling their insurance, in which the increased subsidy would become even more valuable.

Besides the more complicated tax implications, am I thinking correctly about the effects of taking the withdrawal in 2013?

[Jay69]

mlipps,

I have nothing to add to the issue, but kudos to you for helping out your parents in this matter. With healthcare being one of the biggest ticket items for many of us I think its a good thing that you are at least giving them some options as you see them. I'm thinking this could affect your parents comfort level in a big way.

[mlipps]

mlipps,

I have nothing to add to the issue, but kudos to you for helping out your parents in this matter. With healthcare being one of the biggest ticket items for many of us I think its a good thing that you are at least giving them some options as you see them. I'm thinking this could affect your parents comfort level in a big way.

Thanks Jay. Doing my best. Luckily I love personal finance so this is just another fun project for me. My parents think I'm nuts but do what I say as long as they can understand it haha.