Should I Use My Retirement Fund to Pay Parent PLUS Loans?May 25, 2021
If you’re struggling to make your payments on Parent PLUS Loans, you might be trying to find any way that you can stay on track. You may even be wondering, can I use my retirement to pay off student loans?
The answer to that question is yes, you can. But the drawbacks often outweigh the benefits considerably. Before you dip into your 401(k) or individual retirement account (IRA) to make your student loan payments, here’s what you should know.
Can You Use a Retirement Account to Pay Student Loans?
To be clear, there are a handful of ways you can use a retirement account to make your student loan payments.
If you haven’t yet reached the age (59½) at which you can start taking withdrawals from your retirement accounts penalty-free, you’ll be assessed a 10% penalty for withdrawing money from your 401(k) or Traditional IRA.
There are some exceptions to this rule, but paying student loans isn’t one of them.
Some 401(k) plan administrators allow you to borrow money from your retirement plan. While you’ll pay interest, it goes toward your account, not to the plan administrator.
However, the money you borrow is removed from your retirement account, which means it’s no longer earning gains on your investments. This could end up costing you more in the long run.
Also, if you leave your employer while you have a loan, the plan administrator could demand repayment in full. If you can’t pay that now, the loan would be treated as an early withdrawal, and you’d have to deal with the tax consequences.
Roth IRA Withdrawals
Roth IRAs also have an early withdrawal penalty, but it differs from 401(k) plans and Traditional IRAs in one key way: you can withdraw up to the amount you’ve contributed to the account without any taxes or penalties.
This is because Roth IRA contributions are made with after-tax dollars, so that money has already been taxed. But as with a 401(k) loan, taking that money out of your Roth IRA means it’s no longer earning gains from your investments. And if you withdraw more than you’ve contributed to the account, you’ll pay taxes and a penalty on any gains you withdraw.
How Much Could Taking Money from Retirement Cost You?
To give you an idea of the cost in real dollars, let’s say you have $20,000 in Parent PLUS Loans, and you decide to take money from your retirement account to pay them off. You’re 55 years old and plan to retire in 10 years.
For example, with a 401(k) or Traditional IRA withdrawal, you’d pay income taxes plus a 10% penalty on the full $20,000.
The IRS typically requires plan custodians to withhold 20% of your withdrawal for tax purposes — you may get some of this back when you file your return, but only if your effective tax rate is lower than 20%. You may also be assessed a 10% penalty.
So if you withdraw $20,000 from your retirement account, you’ll actually only get $14,000. Instead, you’d need to withdraw $28,572. What’s more, if you were to leave that money in your retirement account and your average annual return for the next 10 years is 5%, that money could be worth $75,810 at retirement.
But again, can I use an IRA to pay student loans without penalty? You can with a Roth IRA, as long as you only withdraw that money you’ve contributed to the account. But you could still miss out on thousands or even tens of thousands of dollars in gains between now and your retirement date, so it’s generally not worth it.
Alternatives to Using a 401(k) to pay off student loans
If you’re considering paying off student loans with a 401(k) or IRA because you’re in dire straits, taking that step could put your financial situation into a much deeper hole.
Instead of using a 401(k) or IRA to pay off student loans, consider these options:
- Switch to an income-driven repayment plan: Parent PLUS Loans qualify for the Income-Contingent Repayment Plan. On the ICR plan, your monthly payment would be the lesser of 20% of your discretionary income or what you’d pay on a fixed 12-year plan, adjusted according to your income. It also extends your repayment term to 25 years. If your income is down, this could make a huge difference.
- Request deferment or forbearance: The Department of Education offers generous deferment and forbearance options. If getting a break from your payments is what you need, contact your loan servicer to discuss your options.
- Refinance your student loans: If you have great credit, you may be able to qualify for a lower interest rate than what you have right now. This alone could decrease your monthly payment, but another benefit of student loan refinancing is that some lenders also offer repayment terms up to 20 years. Extending your term is another way to reduce your monthly payment to a more affordable level.
One thing to keep in mind if you decide to extend your repayment term, either with the ICR plan or student loan refinancing, it could result in you paying more interest overall.
The Bottom Line
Using a 401(k) or IRA to pay off student loans is best considered as a last resort if you’ve exhausted all of your other remedies to the situation. Even then, it’s important that you take the time to consider the costs, including the opportunity cost, of taking money from your retirement account.
Before you go that route, consider other options, including the ICR plan, deferment or forbearance, and even student loan refinancing. While there’s no guarantee that any of these will give you the relief you need, it’s important to consider them, so you can avoid leaving too much money on the table in the long run.