If you’ve been working for a while and contributing to your company’s 401(k), you might feel tempted to use some of that cash to wipe out your student loans – and I don’t blame you.
Saving thousands on interest and allocating those funds toward things, like buying a house or beefing up 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, dipping into your 401(k) before you’re supposed to, shouldn’t be taken lightly. Not only you’ll be cutting yourself short from future earnings, but could also face a hefty tax bill.
Should you withdraw money from your 401(k) to pay off your student loan debt?
Although tapping into 401(k) to pay off your student loans isn’t exactly a terrible idea, Liz Gillette, CFP and director of Planning and Innovation at MainStreet Financial Planning, says that, for the most part, it’s not a “good financial move.”
“While student loans can often seem overwhelming, you want to avoid stripping future investment growth.”
But beyond the possibility of fewer earnings, Gillette points out that withdrawing money from your retirement fund, comes with a series of financial setbacks that could surpass any potential benefits.
Let’s unpack that.
Benefits of withdrawing money from your 401(k) to pay off your student loan debt
You’ll be able to invest your money elsewhere
By wiping out your debt, you’ll have more money available each month to save and invest in other things. You’ll also see a boost in your 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 better qualified for things like an auto loan or a mortgage, and can also help you secure better terms and interest rates, making your future debt less expensive.
You could save a lot on interest
The average rate of return on most 401(k) portfolios is between 8% and 10%, according to financial experts.
If your loans have interest rates higher than 8%, then your debt could be eating away more than you’re earning on interest. In that case, paying off your loans with your 401(k) may be the better option, as you could save thousands on interest, and focus on replenishing your savings.
You can mitigate losses
Because you’re still young, you could catch up on retirement contributions by allocating some of the money that was going toward your student loan payment to your 401(k), mitigating any losses caused by the withdrawal.
Drawbacks of withdrawing money from your 401(k) to pay off your student loan debt
You’ll face a 10% tax penalty – and will need to take out more
Since you’ll be withdrawing money from your retirement account before the age of 59 ½, the IRS will consider this as an early distribution. That means you’ll have to pay a 10% tax penalty on the withdrawn amount.
This penalty is deducted before the payment makes it to you. So, if you need $20,000 to pay off your student loans, you’ll have to withdraw an additional $2,300 from your 401(k) to get to that figure.
You’ll have to pay taxes on top of the penalty
Besides paying a 10% tax penalty, you’ll also have to pay federal and state taxes (where applicable) on the withdrawn amount as the early distribution would count as taxable income. If you’re at the edge of a tax bracket, withdrawing funds from your 401(k) could also bump you into a higher tax rate, increasing your tax liability. Gillette says:
“For investors with a 20% federal tax liability, that 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 matching contributions are vested. So, if you haven’t been working for the company long enough, you won’t have full access to those funds.
Why a 401(k) loan is typically a better option to pay off your student loans than an early withdrawal
If after weighing the pros and cons, you still want to use your 401(k) to pay off your student loans, then Gillette suggests considering taking out a 401(k) loan instead of a withdrawal.
Because 401(k) loans offer several advantages that good old withdrawals don’t offer.
- Not having to pay a 10% tax penalty. Since you’ll be borrowing money, not withdrawing it, you won’t be penalized by the IRS.
- You’ll save money on taxes. The borrowed amount won’t count as part of your ordinary income for that year, so you won’t have to pay any taxes on it.
- Lower impact on your long-term retirement plan. Like Gillette mentioned, since you’ll be paying yourself back — with interest — borrowing money from your 401(k) won’t set you back, in terms of future earnings, as much as a plain withdrawal.
But even if a 401(k) loan is a better option than withdrawing the funds, there are certain considerations you need to keep in mind before taking the plunge.
These 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 have to check with your HR department to see if this is a possibility for you.
- Lower borrowing limits. The IRS only allows you to take out a loan amount equal to 50% of your account balance or $50,000, whichever is less. So, if your student loan balance is higher than that, it may not be worth it.
- High monthly payments. 401(k) loans must be repaid in a five-year period, so if you took out a considerable loan amount to pay off your debt, your monthly bill may be steeper than what you used to pay on your student loans. Still, you’ll be off the hook faster, as most student loans are repaid over a 20-year period.
- You could still be penalized and owe taxes on your loan if you leave your job. If you leave your job before repaying your loan, the full amount will be due on tax day of the following year. If you can’t repay it in full by that date, then the loan will be considered as an early withdrawal by the IRS and you’ll have to pay income taxes on it, as well as the 10% tax penalty.
Before you apply for a 401(k) loan…
Amy Lynn Richardson, CFP with Schwab Intelligent Portfolios, says that the most important thing before touching your 401(k) is to have a plan to replenish those funds.
“This might mean reviewing your budget and identifying areas where you could spend less so that you can increase your 401(k) contributions.”
Kenneth B. Waltzer, a member of the Financial Planning Association (FPA) and managing director at KCS Wealth Advisory, adds that you also…
“need to be very confident that you will remain at your current employer for at least long enough to fully pay off the 401(k) loan.”
This will help you avoid the financial burden of triggering an early withdrawal.
Other alternatives you can explore if you’re struggling with your student loan payments
If after reviewing all the ins and outs of using your retirement account to pay off your debt, you realize that it’s not for you — don’t fret. 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 of the perks of having a federal loan over a private one is that you get access to multiple repayment options that are easier on your wallet than the standard repayment plan.
When you apply for an income-driven repayment plan, your monthly payment is based on your family size and how much you earn, and generally ranges between 10% and 20% of your discretionary income.
You can apply for an income-driven repayment plan by logging into your account on StudentAid.gov.
Read more: 5 Things You Must Know Before Doing An Income-Driven Student Loan Repayment Plan
Consider loan consolidation
By consolidating your federal loans, you’re essentially bundling all of them into one. Besides simplifying your payments, consolidating your loans can help you reduce your monthly bill by offering a longer repayment period of up to 30 years.
The only drawback is that, by extending your repayment term, you may end up paying more on interest long-term, so that’s something to consider before applying for this type of loan.
Read more: Student Loan Consolidation And Refinancing Guide
See if you qualify for public service loan forgiveness (PSLF)
This has been kind of a mess in the past, but the federal government has been making changes to the PSLF program to make it easier for borrowers to get their debt forgiven.
If you’re currently employed by a federal, state, local, or tribal government agency, or at a non-profit organization, you may be eligible to get your remaining federal student loan balance forgiven after making 120 consecutive payments.
Although you’ll pay taxes on the forgiven amount, this will just be a one-time thing. To explore this option, contact your student loan servicer to see if you meet the eligibility requirements before you apply.
Read more: Should I Stick With Public Service Loan Forgiveness?
Put your loans in deferment or forbearance
If you’re experiencing economic hardship, you may want to contact your student loan servicer to see if you qualify for deferment or forbearance.
When your loans are placed on deferment or forbearance, payments are paused temporarily. Still, interest will continue to accrue during this time, so that’s something to keep in mind.
If you have private student loans…
Look into student loan refinancing
Unlike loan consolidation which bundles all your student loans into one, with a student loan refinance you’re taking 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 that’s the case, you could qualify for a better term, plus a lower interest rate, which can make your monthly payments cheaper.
Read more: Student Loan Refinance Options
See if your employer offers student loan repayment assistance
Finally, ask your employer if they offer assistance with student loans. The CARES Act offers tax incentives for employers who offer this benefit, and the Consolidated Appropriations Act extended this benefit through 2025.
Employers may pay up to $5,250 of student loan debt a year per employee. The employee doesn’t have to pay income tax on this money and the company also benefits from a payroll tax exclusion. Your employer may not know about this new benefit, so bring it up to your manager and HR department.
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 consequences before you touch your retirement savings.
If possible, try exploring other alternatives, like an income-driven repayment plan, employee assistance programs, or refinancing to make your debt more manageable. Your older self will thank you!