Should you pay off your student loans using your 401(k) balance?
It’s a common question, especially among people 35 and younger.
And to get to the point, it’s not a great financial move because those under the age of 59 ½ are likely to incur a 10% penalty for making a straight withdrawal.
However, there are other ways to use your 401(k) to help pay down your student loans.
In this article, we’ll discuss:
- The consequences of making an early withdrawal from your 401(k)
- What to know about 401(k) loans for education
- Alternatives to paying off your student loans with a 401(k)
- When paying off debt with your 401(k) can make sense
Let’s get started…
Consequences of Withdrawing From Your 401(k)
The IRS charges a 10% penalty for making an early 401(k) withdrawal. Plus, withdrawals from traditional 401(k)s are subject to income tax. There is no exception for student loan payments.
Here’s an example to illustrate how costly withdrawing early from a 401(k) can be.
- Jane has $20,000 in a traditional 401(k) and an $18,000 student loan balance at a fixed 6% interest rate. Her monthly student loan payment will be $348 for the next five years.
- The 10% penalty Jane will have to pay reduces the net value of her 401(k) to $18,000.
- In addition to that penalty, Jane’s 401(k) withdrawal is taxable income. So if we estimate Jane’s average tax rate at 20%, she would owe an extra $4,000 in taxes.
- This makes the net value of her 401(k) — after taking a withdrawal — just $14,000.
On the positive side, Jane would end up saving $2,879 in interest over the next five years by paying off her student loans today.
However, over five years, $20,000 (the original amount of her retirement funds) compounded at 7% (a reasonable rate of return on investments) grows to $28,051.
The important factors to consider for your own situation include:
- The total amount withdrawn from your 401(k)
- Your federal income tax rate*
- Your state income tax rate
- The estimated rate of return on your 401(k)
- Your student loan interest rate
- What you plan to do with the money you no longer have to pay towards student loans (save for a house, continue to invest, etc.).
*You not only owe taxes this year, but will also lose the ability to deduct student loan interest from your taxable income.
To help calculate what you’d pay in taxes and penalties, I found this calculator from TIAA to be the most helpful.
Note: If you’ve contributed to a Roth 401(k) instead of a traditional account, know that just the investment earnings are taxed (not your contribution).
Key Point: If you’re under the age of 59 ½, you’ll incur a 10% penalty for making a withdrawal from your 401(k) to pay off your student loans.
Borrowing From Your 401(k) to Pay Off Student Loans
An alternative to withdrawing from a 401(k) to pay off your student debt is a 401(k) loan.
401(k) loans work similarly to other personal loans for paying off debt. However, instead of paying back a bank or other lender, you have to pay back your own 401(k) account.
If you’re considering this route, there are a few things to know:
- Loans are not taxed as income, as long as they’re paid back on time.
- Defaulting on a 401(k) loan means you’ll have to pay income tax and a 10% early withdrawal penalty on the balance.
- The maximum you can borrow from a 401(k) is 50% of your vested account balance up to a maximum of $50,000.
- Terms (such interest rates and availability) are determined by your employer.
- No income tax or penalties on a 401(k) loan (unless you can’t pay it back).
- You pay back yourself, including interest, instead of losing money on interest to a bank.
- Significant downsides if you don’t pay the money back, as the loan is treated as taxable income.
- Not all 401(k) plans allow for loans.
- The amount you withdraw loses the ability to appreciate in value.
- Interest rates on student loans and 401(k) loans are likely not much different.
- Interest on 401(k) loans is not tax-deductible, whereas student loan interest is.
My thoughts on 401(k) loans to pay back student debt: The key factor is the interest rate you’re paying on your student loan. As the national average interest rate for student debt is around 6%, this rate is likely very similar to what you’d pay to borrow from your retirement account. As such, for most individuals, there’s little benefit and significant downside risk.
Also keep in mind that there are at least some options for those struggling to make their monthly payment on their student loans, such as deferment. There are no such options with 401(k) loans, and you’re likely to incur a very big tax bill if you’re unable to meet your agreed-upon terms.
Related reading: A four-step guide to paying off your student loans in five years.
Alternatives to Paying Off Your Student Loans With a 401(k)
So far, we’ve focused on two concepts:
- Taking an early withdrawal from your 401(k) to pay off your existing student loans.
- Borrowing from your 401(k) to pay off your existing student loans.
Now that you know the facts, hopefully you’re beginning to see that these options are costly over the long term.
But there are alternative options for those considering a 401(k) withdrawal for education. And these options may make sense not only for individuals who want to pay off their existing student loans, but also for those wondering whether it makes sense to withdraw from a 401(k) to pay for future education expenses.
Option #1: Be Patient
A common reason people consider paying off their student loans with a 401(k) is because they simply want freedom from debt. They’re tired of their student loan payments, and making that last one would feel great.
Closely related, I’ve found that many people who follow Dave Ramsey’s baby steps — which say that you should pay off all non-mortgage debt before investing — wonder if they should use their 401(k) their to pay off their student loans.
My belief is that it’s important to make personal finance personal. Specifically, you have to do what you feel is best for you. However, the numbers are still the numbers, and laws are still laws. You can’t hide from either of these things.
In other words, there are significant monetary costs to making a withdrawal from your 401(k). There are also severe consequences for not being able to pay back a 401(k) loan. So, the freedom you’re supposedly getting in the short-term may be quite costly in the long-term.
If you really want to eliminate your student loans, an alternative plan might be:
- Don’t touch your 401(k) balance and continue to invest up to your employer match.
- Look for ways to save more money each month and apply the savings to your student loans.
- Increase your income, which may mean taking a higher paying job or earning money on the side.
- Once your income is up and your job situation looks good, look to refinance your student loans to a lower interest rate.
- With a consistent (and hopefully, growing) gap between your income and expenses, you’ll have more resources to apply to paying off your student loans early.
It’s this type of behavior that’s going to allow you to build real wealth. And, in a sense, you can look at your short-term goal of paying off your student loans as a chance to increase your wealth-building skills.
Option #2: Individual Retirement Accounts (IRAs)
What about using an IRA to pay off existing student loans?
The laws that govern IRA distributions are very similar to those that govern 401(k)s. Specifically, you’ll pay a 10% early withdrawal penalty, and withdrawals from a traditional IRA are subject to income tax.
The tax laws are a little more friendly for Roth IRAs, as you can withdraw your contributions at any time without a penalty. For example, if you invested $5,000 into your Roth IRA and your balance is now $6,000, you can withdraw up to $5,000 tax and penalty fee.
In short, you’re dealing with a lot of the same downsides that come with taking a 401(k) withdrawal.
However, it’s important to discuss IRAs because the IRS does exempt certain higher education expenses from the 10% penalty.
So, while you can’t use an IRA to pay off existing student loans without incurring a 10% penalty, you can use it to pay off current education expenses.
Key Point: Using an IRA withdrawal to pay off your student loans has many of the same downsides as 401(k)s. The IRS, however, does allow penalty-free withdrawals from an IRA to pay for qualified education expenses.
Option #3: 401(k) Hardship Withdrawals
Taking a hardship withdrawal is not an option for those looking to pay off existing student loans. It is, however, an option for those looking to pay for current education expenses.
You need to qualify for a hardship withdrawal, which means proving that your need for an early withdrawal is immediate and heavy. So, if you have other assets that could be used, you’ll likely be denied.
You apply for a hardship withdrawal through your employer, who then has to determine whether your need for the funds is “immediate and heavy.” While the IRS does list “education and tuition” as an expense that may qualify, your employer may not.
Personally, I would prefer to take out a student loan in this situation, rather than raiding my 401(k), as the former generally have favorable interest rates and payment options.
Option #4: The “Setting Every Community Up for Retirement Enhancement Act” (SECURE)
The SECURE Act, passed and signed into law in late 2019, allows for 529 college savings plan holders to withdraw a lifetime maximum of $10,000 to pay off existing student loans.
Withdrawals are tax-free and penalty-free at the federal level. However, your state may consider this a non-qualified 529 withdrawal, and it may therefore be subject to state income tax.
More upcoming legislation? Also in late 2019, Senator Rand Paul introduced the HELPER Act, which would allow for tax-free and penalty-free distribution of up to $5,250 from a 401(k) and IRA. This is something to keep an eye on in the future, although ScoopsLabs says it has less than a 1% chance of passing.
When Paying Off Debt With Your 401(k) Makes Sense
When you run the numbers, it would very rarely make sense to use your retirement savings to pay off existing student loan debt.
This is based on the premise that average student loan rates are around 6%, and income tax aside, you’re paying an immediate 10% tax penalty for withdrawing from a 401(k). In other words, you’re down 4% as soon as you start — and likely a lot more once you account for income taxes.
In the example above, there was a 30% total cost of withdrawing from your 401(k). As such, using that to pay off the debt at 6% (or even a little higher) doesn’t make financial sense.
Final Thoughts on Paying Off Student Debt
It’s a good thing to want to eliminate your student loans. But as we discussed above, using your 401(k) to do that isn’t, generally speaking, a wise long-term decision. And it can actually be very expensive.
It may take a few extra years to finally get rid of those student loans by doing the hard work to reduce your expenses and increase your income, but you’ll be so far better off over that time if you can avoid raiding your retirement funds.
And more importantly, the skills you build in accomplishing this feat will serve you very well for the rest of your life.