Should you pay off student loans with your 401(k) balance?
Here’s a common scenario, especially among those under 35.
Let’s say I’m talking with my friend Joe. Joe is in his mid-to-late 20s
After graduating from a college, Joe has been working hard to make a quality living for himself.
As Joe increases his income, he takes an interest in personal finance. Joe reads that one should pay off their student loans before starting to invest.
Joe starts to wonder:
“If someone shouldn’t start investing up until their debt free, should I pay off student loans with my 401(k)?
Up until now, Joe has been making minimum payments on his student loans.
Since Joe started working a corporate job, he’s been contributing to a 401(k). Taking advantage of his employer’s match.
As for his expenses, Joe spends a bit less than he makes. Some months a bit more, most months a bit less.
Joe is doing pretty well. He’s got no credit card debt, got some cash stocked away for emergencies. He has some money to enjoy himself.
But the one thing bothering Joe is his student loans. Joe thinks of all the possibilities if he didn’t have to make student loan payments. At a 7% interest rate, his student loans don’t seem to be going down.
If Joe was able to knock out those student loans, which he can do with his balance in his 401(k), should he do it?
Let’s dive in.
Should You Pay Off Student Loans With Your 401(k) Balance?
Joe has $20,000 in a Traditional 401(k) and $18,000 left in student loans at a 7% interest rate.
The first thing to know is that there’s a withdrawal penalty for taking money out of your 401(k) before 59½. That penalty is 10%. There is no exemption for student loans.
Besides the penalty, Joe’s 401(k) withdrawal is taxable income. The withdrawal increases his income for the year, putting him in a 25% tax bracket.
In this scenario, 35% of the $20,000 in his 401(k) would be going to taxes and penalties. Leaving Joe with $13,000.
As you can see, in this specific scenario, it’s hard to make the case for Joe to withdraw from his 401(k) to pay off his student loans.
Pay Off Your Student Loans With Roth 401k?
What if Joe contributed to a Roth 401(k) instead?
Keeping the numbers the same, what should Joe do now?
Joe would still owe taxes on earnings his Roth 401(k) generated. Say Joe has contributed $12,000. Gains make up the remaining $8,000.
In the case of a Roth 401(k) only the gains count towards taxable income.
So, Joe would pay a 10% penalty on the $20,000 balance. Then, let’s say 22% tax on the $8,000 in gains.
In this case, the cost to withdraw his money would be $2,000 in penalties and $1,760 in taxes.
Joe would be looking at two options here:
- Using the $16,240 he has in cash to knock off most of his student loans.
- Keep the $20,000 in his 401(k), which would earn on average 7% a year.
While you can argue for the freedom that Joe would have paying off most of his student loans, mathematically it still doesn’t make sense.
To look at it another way, Joe would be borrowing money at 19% to pay off a debt with a 7% rate.
Borrow from 401(k) to Pay Off Student Loans?
Joe also learns about borrowing from his 401(k).
Joe learns that the limits for borrowing on a 401(k) are 50% of the total balance or $50,000, whichever is less.
So, Joe could borrow $10,000.
Should Joe do it?
If Joe could borrow at 5% and pay off his student loans which are at 7%, he should do it right?
Student loan interest is tax deductible. The interest you pay on your 401(k) loan isn’t.
I also explain to Joe that a loan not paid back is considered an early withdrawal–subject to a 10% penalty and included in his taxable income.
Also, student loan debt comes with some flexibility such as deferment and in some cases forgiveness. Therefore, making it a much more attractive debt to carry than a 401(k) loan.
So for the risks, Joe understands it’s not worth it.
Other Options: Pay Off Student Loans With A 401k?
Joe’s goal is to pay down his student loans quickly.
He wants to pay off his student loans for the supposed freedom this grants him.
But as we dive into the mathematics, this supposed freedom is very expensive.
As Joe and I continue to talk, I let him know that he’s limiting himself.
The only option he is thinking about is to pay off student loans with his 401(k) balance.
Another plan Joe should consider would be to:
- Don’t touch his 401(k) balance and continue to invest up to his employer’s 401(k) match
- Look for ways to save more money each month. Apply the savings to his student loans.
- Increase his income. Which may include taking a higher paying job or earn money on the side.
- Once the income is up and the job situation looks good, look to refinance to a lower interest rate.
- Stop contributing to his 401(k) while he focuses on eliminating his student loans ASAP
- Then, just repeating steps #2-4 from above.
If Joe is able to increase his monthly cash flow by $1,666 a month, he could pay off his student loans in a year. Plus, maintain or grow his current balance.
This is real freedom.