If you have been working and contributing to your company’s 401(k) for a while now, you might be tempted to use some of that money to pay off your student loans – and I don’t blame you.
Saving thousands in interest and using those funds towards things like buying a house or boosting your savings sounds like a good plan, especially if you’re light years away from retirement.
But even if it seems like a good idea, diving into your 401(k) earlier than you should should not be taken lightly. Not only will you deprive yourself of future income, but you could also face a huge tax bill.
Do you have to withdraw money from your 401(k) to pay off student loan debt?
While using a 401(k) to pay off student loans isn’t such a bad idea, Liz GilletteCFP and Director of Planning and Innovation at Financial planningsays it’s not “a good financial move” for the most part.
“While student loans can often seem overwhelming, you shouldn’t deprive future investment growth.”
But Gillette notes that, in addition to the possibility of making less money, withdrawing money from your pension fund comes with a series of financial setbacks that could outweigh any potential benefits.
Let’s unpack this.
Benefits of withdrawing money from a 401(k) account to pay off student loan debt
You will be able to invest your money elsewhere
By paying off your debt, you will have more money each month to save and invest in other things. You will also see an increase debt to income ratio (DTI)which is a percentage that measures how much of your monthly gross income is compromised by your debts.
Having a lower DTI can make you more qualified for things like Auto loan or mortgageand can also help you secure better terms and interest rates, making your future debt less expensive.
You can save a lot on interest
The average rate of return for most 401(k) portfolios is between 8% and 10%. according to financial experts.
If your loans have interest rates above 8%, then your debt may be eating up more than you earn in interest. In this case, paying off your loan with a 401(k) may be the best option, as you can save thousands in interest and focus on adding to your savings.
You can reduce losses
Because you’re still young, you can catch up on retirement contributions by funneling some of the student loan money into your 401(k), reducing any losses caused by withdrawals.
Disadvantages of withdrawing money from a 401(k) account to pay off student loan debt
You will face a 10% tax penalty – and you will need to take out more
Because you will be withdrawing money from your retirement account before age 59.5, the IRS will treat this as an early allocation. It means you will have to pay a 10% tax penalty on the withdrawn amount.
This penalty is deducted before the payment reaches you. So if you need $20,000 to pay off student loans, you’ll have to withdraw an additional $2,300 from your 401(k) to get that figure.
You will have to pay taxes on top of the fine
In addition to paying a 10% tax penalty, you will also have to pay federal and state taxes (where applicable) on the withdrawn amount, as the early distribution would be treated as taxable income. If you are on the edge of the tax bracket, withdrawing funds from your 401(k) may also result in a higher tax rate, increasing your tax liability. Gillette says:
“For investors with a 20% federal tax liability, this means 30% of the proceeds could disappear due to taxes and penalties.”
You may not be able to use your entire balance
Most employers require you to work for a certain number of years before their respective contributions are secured. So, if you haven’t been with the company long enough, you won’t have full access to these funds.
Why a 401(k) loan is generally a better option for paying off your student loans than early withdrawal
If, after weighing the pros and cons, you still want to use your 401(k) to pay off student loans, then Gillette suggests considering getting a 401(k) loan instead of withdrawing.
Why?
Because 401(k) loans offer several benefits that the good old withdrawals don’t.
These include…
- No need to pay a fine of 10%. Because you will be borrowing money, not withdrawing it, you will not be penalized by the IRS.
- You will save money on taxes. The amount borrowed will not count as part of your regular income for that year, so you won’t have to pay any taxes on it.
- Less impact on your long term retirement plan. As Gillette mentioned, since you’ll be paying back the debt – with interest – borrowing money from your 401(k) won’t cost you as much in terms of future earnings as simply withdrawing.
But even if a 401(k) loan is a better option than a withdrawal, there are certain considerations to consider before taking the plunge.
Here are some of the most important ones:
- Not all employers offer this loan. Some employers don’t offer 401(k) loans as part of their plan, so you’ll need to check with your HR department to see if this is an option for you.
- Lower credit limits. The IRS only allows you to borrow up to 50% of your account balance or $50,000, whichever is less. So, if your student loan balance is higher than this, it might not be worth it.
- High monthly payments. 401(k) loans must be repaid within five years, so if you took out a significant amount of credit to pay off your debt, your monthly bill may be higher than the one you used to pay off student loans. However, you will get off the hook faster because most student loans pay off within 20 years.
- You can still be fined and have to pay taxes on the loan if you leave your job. If you leave your job before the loan is paid off, the full amount will be paid on tax day next year. If you fail to repay it in full by that date, then the IRS will treat the loan as an early withdrawal and you will have to pay income tax on it, as well as a 10% tax penalty.
Before you apply for a 401(k) loan…
Amy Lynn RichardsonSFP with Schwab Smart Portfoliossays the most important thing before touching a 401(k) is to have a plan to replenish those funds.
“This could mean reviewing your budget and identifying areas where you could spend less so you can increase your 401(k) contributions.”
Kenneth B. Walzermember Financial Planning Association (FPA) and Managing Director at KCS Welfare Adviceadds that you also…
“must be very confident that you will stay with your current employer at least long enough to pay off your 401(k) loan in full.”
This will help you avoid the financial burden associated with early withdrawals.
Other Alternatives You Can Explore If You’re Struggling With Student Loan Payments
If, after familiarizing yourself with all the intricacies of using a retirement account to pay off debt, you understand that this is not for you, do not be discouraged. There are other options available that can help make your debt more manageable.
If you have federal student loans…
Apply for an income-driven repayment plan (IDR)
One advantage of a federal loan over a private one is that you get access to multiple repayment options that are easier on your wallet than a standard repayment plan.
When you apply for income-adjusted repayment planyour monthly payment depends on your family size and how much you earn, and is usually between 10% and 20% of your discretionary income.
You can apply for an income-based repayment plan by logging into your account at StudentAid.gov.
Read more: 5 things you should know before you complete an income-focused student loan repayment plan
Consider Loan Consolidation
From consolidation your federal loans, you basically combine them all into one. In addition to making your payments easier, consolidating your loans can help you cut your monthly bill by offering a longer repayment period of up to 30 years.
The only downside is that by extending the repayment term, you may end up paying more in interest in the long run, so this should be considered before applying for this type of loan.
Read more: Student Loan Consolidation and Refinance Guide
Find out if you qualify for Public Service Loan Forgiveness (PSLF)
It’s been kind of a mess in the past, but the federal government is making changes to FPLF program to make it easier for borrowers to get debt forgiveness.
If you currently work for a federal, state, local, or tribal government agency or non-profit organization, you may be eligible to write off your remaining federal student loan balance after making 120 consecutive payments.
Although you will pay taxes on the forgiven amount, it will be a lump sum. To explore this option, contact your student loan provider to see if you meet the eligibility requirements before you apply.
Read more: Should I stick to public service loan forgiveness?
Put your loans in grace or patience
If you are experiencing economic hardship, you can contact your student loan provider to find out if you qualify for a deferment or forbearance.
When your loans are put on hold or forfeit, payments are temporarily put on hold. However, interest will continue to accrue during this time, so keep that in mind.
If you have private student loans…
Look at student loan refinancing
Unlike loan consolidation, which combines all your student loans into one, with student loan refinancing you take out a new loan with a new term and interest rate to pay off your old debt.
Now that you’ve been working for a few years, chances are you have a higher credit score than when you first took out your private loans. If so, you may qualify for a better term plus a lower interest rate, which can make your monthly payments cheaper.
Read more: Student Loan Refinancing Options
Find out if your employer offers student loan assistance.
Finally, ask your employer if they offer student loan assistance. The CARES Act offers tax breaks for employers who offer the benefit, and the Consolidated Appropriations Act has extended the benefit through 2025.
Employers can pay up to $5,250 in student loan debt per year per employee. The employee does not have to pay income tax on this money, and the company also enjoys a payroll tax exemption. Your employer may not be aware of this new benefit, so let your manager and Human Resources know.
Summary
Having student debt can be stressful, especially if your loan balance is on the higher side. Taking money from your 401(k) to pay off your loans can put your mind at ease, but it’s important to understand the financial implications before touching your retirement savings.
If possible, try exploring other alternatives, such as an income-based repayment plan, employee assistance programs, or refinancing to make your debt more manageable. Your adult self will thank you!