Should You Withdraw From Your 401(k) to Pay Off Student Loans?January 26, 2022
Due to the rising cost of college, many graduates are saddled with large student loan payments upon graduation. Student loan debt repayment is a top priority for many people who are looking to take control of their monthly spending.
Student loan payments can put a major dent in monthly budgets, preventing people from focusing on other savings goals. When you have a growing balance in your 401(k) you may ask yourself “can I use my 401k to pay off student loans?”. Although it is possible to withdraw funds from a 401(k) retirement account, you should consider the impact it will have on your retirement and review other alternatives first.
Here we will explain the consequences of using funds from a 401(k) to pay off student loans and alternatives to explore.
Rules for Withdrawing From Your 401(k)
Can you use your 401k to pay off student loans? The short answer is yes, but since the funds in your 401(k) are meant for retirement, there are many rules for withdrawing funds prior to that time. It is important to fully understand the guidelines for withdrawing before using money from your 401(k) to pay off student loans. Here are the rules to know:
- You will pay a 10% penalty tax for withdrawing money from your 401(k) if you are under 59 ½ years old.
- You will need to pay federal income taxes on the withdrawn amount.
- Some states may require you to pay state income taxes on the amount you withdrew.
- An exception to the withdrawal penalty is an IRS guideline known as the rule of 55. If you are age 55 or later (or in the calendar year you turn 55) and leave your job for any reason, whether your own doing or by your company, you can withdraw funds from your 401(k) penalty free. You will still owe income taxes though.
Borrowing From Your 401(k)
If the 10% penalty discourages you from withdrawing from your 401k to pay off student loans, you may be able to borrow from your 401(k) instead. However, not all plan administrators provide the option of loans.
If loans are allowed, be sure to check with your plan administrator for exact details on amount allowed, interest rate, and time frame for repayment as these can vary. Here are the general IRS rules for borrowing to be aware of:
- You can only borrow from vested funds in the 401(k).
- There is a limit to how much can be borrowed, up to 50% of the vested amount or up to $50,000, whichever is greater.
- You can borrow multiple loans as long as you do not exceed the maximum amount borrowed of $50,000 total.
- Loans are not subject to income tax.
- Loans generally have to be repaid in five years, although your plan administrator may have a different loan length.
- According to the IRS, payments must be made in equal payments made at least quarterly and consist of principal and interest.
- The interest payments are put back into your 401(k) since your vested money was used to make the loan.
Although you may hear about hardship withdrawals when you are considering using your 401k to pay off student loans, hardship withdrawals are not permitted to repay student loans even if you are struggling to keep up with your monthly payments.
A hardship withdrawal is allowed for emergency needs, defined by the IRS as “an immediate and heavy financial need”. In some circumstances, using the money for college tuition may be allowed, but you would still owe income tax on the money.
Consider Early Withdrawal Penalties
Early withdrawals will result in a significant penalty, which can mean a hit to your retirement savings. Therefore, in order to net a certain amount, you need to factor in the penalty and income tax you will owe for the withdrawal. This is how early withdrawal penalties will affect you:
If you are under 59 ½ and do not fit the 55 rule exception noted above, you will owe a 10% penalty. Meaning if you withdraw $25,000, $2500 will be taken out for the penalty in addition income taxes will be owed on the full $25,000 come tax time.
Long-Term Risks of Using Your 401(k) to Repay Student Loans
Not only do you face the possibility of paying a penalty and owing additional income taxes when using your 401(k) to pay off student loans, but there are also long-term consequences such as missing out on compounding interest when the money is withdrawn. This will cause you to have less money for retirement.
Even if you repay the money or make additional contributions, you will be playing catch-up on your retirement savings. Also, consider your possible rate of return for your retirement account versus the interest rate you are paying on your student loans. There are ways to reduce your student loan interest rate and monthly payment to make it more manageable, so consider other options first.
Consider Other Options if You Are Struggling With Repayment
If you are struggling with student loan repayment, before you ask, “Can I use my 401k to pay off student loans?” consider other student loan debt relief measures. Here are some debt relief options to consider:
- Income-Driven Repayment: If you have federal loans, consider applying for this type of plan, which calculates your monthly payment based on your income and family size.
- Student loan forbearance or deferment: If you’re eligible, these options may freeze your federal student loan payments for up to a year based on different circumstances. Be sure to research whether interest will continue to accrue during this time.
- Work with your lender: For private student loans, contact your lender about your difficulty with paying. Some may offer forbearance programs or temporarily reduce your payment.
- Charities & donors that help repay student loans: If you are struggling with repayment, certain charitable or nonprofit organizations may be able to help.
- Student loan forgiveness: Certain professions and sectors of work can qualify for student loan repayment assistance or forgiveness.
Alternatives to Repay Student Loans Faster
Student loan debt can be a burden, even if your monthly payment is manageable. If you are focused on paying off student loans early, there are other advantageous options and strategies to consider before tapping into your 401k to pay off student loans:
- Student loan refinancing: Refinancing allows you to obtain a new student loan to pay off previous student loans. You may have the opportunity to lower your student loan interest rate and change your repayment term.
- Withdrawing funds from an IRA: If you have a Roth IRA, you can withdraw your contributions at any age without the risk of penalty or taxes, as long as you do not withdraw any earnings. Withdrawing funds from a traditional IRA will result in an early withdrawal penalty if done before the age of 59 ½ just like with a 401(k).
- Making extra payments: Whether with extra money from your budget or money you receive in a windfall, extra payments can help save on interest costs and knock your balance out quicker.
- Starting a side hustle: Earning extra money outside of your day job can be a great source to pay debt off. Start with selling unused items around your house or picking up dog-walking jobs. Every little bit can help.
- Create and stick to a budget: Determine how you spend your money and see if there are categories that can be eliminated or cut back to allow for more money to be put towards your loans.
Refinance Your Student Loans With ELFI Today
If you are determined to pay off your loans quickly, student loan refinancing is a great option.
There are many benefits of student loan refinancing, including the opportunity to lower your interest rate and change your repayment term. To get an idea of how much you could save, use ELFI’s student loan refinancing calculator.*