Middle Age Money Mistakes

Mellody Hobson talks about common money mistakes people make in their middle ages in today’s “Money Mondays” segment.

I know no one really likes to identify themselves as middle aged, so I’m not pointing any fingers! But money advice tends to focus on young people and all the financial pitfalls they should avoid—and that’s great because we need to teach our kids about money. But the truth is that the stakes are even higher for older people. For one thing, bad financial habits are more ingrained and harder to break. Plus, the middle aged set has less years left in the workforce and less time to save until retirement. The stark reality is that financial missteps in middle age can have dire consequences down the line, and sometimes there’s just not enough time to right to ship.

Wisdom doesn’t necessarily accompany age when it comes to money, it seems. Last week I warned young people about cashing out their 401(k) plans when they switch jobs. But get this: People in their 40s and 50s are making the mistake of borrowing from their 401(k) plans, typically to pay for their kids’ college educations. It’s no wonder why—college costs are rising by at least twice the inflation rate every year. The College Board just reported the average price for tuition and fees at a public four-year school as nearly $9,000, and that figure more than doubles if you add on room and board. If you want to attend that same public four-year school as an out-of-state student, tuition more than triples from $9,000 to $22,000, and it’s another $9,000 a year for room and board.

No one wants their child to come out of college saddled with debt, but borrowing against your 401(k) is not the lesser of two evils. There’s a fundamental philosophy here that needs to change: A 401(k) plan is a savings vehicle, NOT a bank account.

So paying for your kids’ education shouldn’t derail your retirement?

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And I’ll say it again. Data released by the Federal Reserve Bank of New York last year shows that middle-aged Americans are actually the age group struggling the most with student loan payments. Not only has the number of middle-aged Americans in their 50s with student loans doubled since 2005, the delinquency rate (90 days or more without payment) for borrowers ages 40 to 49 was 11.9%, compared to a delinquency rate of 8.7% for borrowers of all ages.

It’s true that some of those over-40 debtors are still paying off their own loans from college, but data analysts agree that many are actually parents who have taken out student loans to help fund their children’s education.

In fact, the federal PLUS program, which allows parents to take out loans for their kids to help pay education expenses not covered by other financial aid, is among the fastest-growing of the government’s education loan programs.

Keep in mind that the beneficiary of your loan is likely sitting on a bean bag chair eating a microwaved burrito right now. Absolutely, help your kids as best you can, but remember, there’s no loan to pay for retirement, so that plan has to be squared away first.

Something else to consider: the current interest rate on Direct PLUS loans is a fixed 6.41%. If parents were to take out a PLUS loan for $25,000, and repay it over the course of 10 years, mom and dad would end up paying nearly $300 a month, making the original $25,000 loan cost nearly $34,000 at the end of ten years.

If, however, they instead put that $300 a month into a Roth IRA for 10 years at 7% interest, they would have over $53,000 saved for retirement. When it comes to interest rates and time, the magic of compounding can work either for you or against you.

And that leads me to my final tip for our more seasoned listeners: The tax man cometh.

Unless you have a Roth IRA or Roth 401(k) retirement plan, there’s someone else with a vested interest in your retirement plan—the I.R.S. With a Traditional IRA or 401(k), your contributions are pre-tax and your earnings are tax deferred. That means you don’t pay any taxes until you take the money out. The I.R.S. is eagerly awaiting your withdrawals from your retirement plan because it’s a payday for them too. Many people assume they’ll be in a lower tax bracket when they retire, but this may or may not be the case. It’s a situation of “Pay the piper now or pay the piper later,” but no matter which way you slice it, Uncle Sam’s gonna blow that horn. Roth IRAs and Roth 401(k) plans are no-brainers for young people because the earnings on their contributions have decades to grow tax-free. It gets a little trickier for the older set, especially if there are numerous financial obligations like a mortgage and kids’ tuition fees. Deferring earnings with a Traditional 401(k) plan keeps this year’s tax bill lower.

Consider this: In the 1970s, the top marginal tax bracket was 70%, and in the early 80s, it dropped to 50%. Today, the top marginal tax bracket for earned income is 39.6%. Who knows what tax rates will be 30 years from now. But if they head back up, we may regret not having invested in the Roth 401(k) versus the Traditional 401(k).

Mellody is President of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts.  Additionally, she is a regular financial contributor and analyst for CBS News.