Should You Pay Off Student Loans With Your 401(k)?

If you have student loan debt and a sizable 401(k) balance, you may be tempted to tap your retirement account to pay down your educational debt. 

While early withdrawal from a 401(k) typically results in a hefty income tax bill and a 10% penalty, some 401(k) providers allow you to borrow from your retirement plan and pay yourself back without those consequences.

A 401(k) loan provides some advantages, but there are some significant risks to consider. Depending on your balance, you may not even be able to borrow enough to cover your student loan balance. Here’s what to know about how 401(k) loans work and their pros and cons. 

How does a 401(k) loan work?

A 401(k) loan involves borrowing money from your employer-sponsored retirement plan. If your plan allows loans—not all do—you can typically borrow the lesser of $50,000 or 50% of your vested 401(k) balance. 

Some employers set a vesting schedule for matching contributions, giving you full access to those funds over time rather than upfront. You can use those funds for anything you want, including paying off federal or private student loan debt. You’ll then repay the loan over five years, usually via payroll deductions.  

Interest rates on 401(k) loans are relatively low—usually the Wall Street Journal prime rate plus a margin of 1% or 2%. Because you’re borrowing from yourself, you don’t need to undergo a credit check to get approved. Also, both the principal and interest you pay go back into your account. You may, however, need to pay some upfront fees to the plan administrator to process the loan.

That said, 401(k) loans are still generally a bad idea, especially as a way to pay off student loan debt. In addition to certain risks—more on those in a minute—the costs can be incredibly high, primarily due to lost earnings on your investments. Other options to consider include:

• Income-driven repayment plans
• Student loan forgiveness programs
• Student loan forbearance and deferment options
• Student loan refinancing

What to consider before you use a 401(k) loan to repay student debt

Before you talk to your 401(k) plan administrator about a loan, here are some questions to consider.

Ask the expert

Chloe Moore

CFP®

Taking a 401(k) loan for any reason can result in less money for retirement. You’re not only missing out on the potential growth from your investments, you may also need to reduce your 401(k) contributions while you’re making payments on the loan. This could easily set back your retirement savings long term.

Can you afford the monthly payment?

The standard repayment term for a 401(k) loan is five years, which is half the standard repayment plan for federal student loans. Also, depending on the current prime rate, the interest rate on a 401(k) loan may be higher than what you’re currently paying on your student loans.

Look at your budget and run some numbers to determine whether a 401(k) loan payment is feasible.

Is there a chance you’ll leave your job?

If you leave your job or get laid off, your five-year repayment plan will be nullified. Instead, you’ll need to pay the full remaining balance by the due date for your federal tax return, including extensions, for the tax year in which your employer offset your account for the amount of the unpaid balance. 

If you can’t afford it, the unpaid balance will be treated as an early withdrawal and, therefore, subject to income taxes and a 10% penalty.

For example, let’s say you took out a $25,000 loan two years ago and have paid back $10,000. Your employer lays you off in November, giving you until the following April—or October, if you file an extension—to pay back the remaining $15,000. 

Your 401(k) plan administrator will report the $15,000 as an early distribution if you don’t. If you have an effective income tax rate of 12%, you’d end up paying $1,800 in income taxes plus a $1,500 penalty, for a total of $3,300. 

Are you comfortable giving up federal borrower protections?

Paying off federal student loans with a 401(k) loan will result in you giving up important borrower protections.

That includes access to Public Service Loan Forgiveness and other forgiveness programs, certain government student loan repayment assistance programs, and income-driven repayment plans.

Were you planning to deduct student loan interest on your taxes?

Many student loan borrowers are eligible to take a tax deduction for student loan interest of up to $2,500. In contrast, 401(k) loan interest is not tax-deductible.

Do you think you’ll want deference or forbearance options if you can’t make payments? 

You do get some flexibility with 401(k) loan payments because there’s no set repayment plan. You just need to ensure you’re making substantially equal payments, at least quarterly. 

However, you can’t just stop paying on a 401(k) loan if you return to school or experience financial hardship like you can with federal student loans. And as previously mentioned, defaulting on your 401(k) loan can cost you thousands of dollars in taxes and penalties.

Pros and cons of a 401(k) loan to repay student debt

While there are some benefits to using a 401(k) loan, 

Pros

• No credit check

  Because you’re borrowing from yourself, you don’t need to deal with a credit check. This may make a 401(k) loan more appealing to someone with less-than-stellar credit who may not be eligible for student loan refinancing.

• You’re paying yourself

  Instead of paying interest to a lender, all of your payments go back into your 401(k) plan.

• No taxes and penalties if repaid on time

  Compared to just taking money out of your retirement plan, a 401(k) loan allows you to avoid costly income taxes and penalties as long as you can pay back the debt. 

Cons

• Defaulting can be costly

  If you can’t afford to repay the loan on time, or you quit your job or get laid off, a large portion of the balance could be treated as an early withdrawal, resulting in income taxes and a 10% penalty.

• You’ll miss out on investment gains

  When you take out a 401(k) loan, that money no longer generates investment returns. And while the interest you pay can help mitigate some of that cost, you’ll ultimately gain more in the long run by leaving your retirement funds where they belong.   

• You may lose borrower protections

  If you use a 401(k) loan to pay off federal student loans, you’ll no longer have access to the borrower protections and relief programs that the Department of Education provides. 

There are very few situations in which I’d recommend withdrawing from a 401(k), and I would generally recommend it as a last resort. 

Chloe Moore

CFP®

Alternatives to repay student loans

Instead of using a 401(k) loan to repay your student debt, here are other options to help you accomplish your goal. 

Refinance student loan debt

Refinancing your student loans with a private lender could allow you to secure a lower interest rate than what you’re currently paying. This option is particularly worth considering if you have private student loans. 

If you have federal student loans, you’ll still run into the same issue of losing borrower protections. But if you don’t anticipate needing those relief options, student loan refinancing comes with far fewer risks than a 401(k) loan.

Consolidate federal student loan debt

If you only have federal student loans, you can simplify your monthly payments and get on a different repayment plan by consolidating them via the Direct Loan Consolidation program.

Remember that federal loan consolidation won’t result in a lower interest rate. In fact, your new interest rate will be the weighted average rate of the loans you’re consolidating, rounded up to the nearest one-eighth of a percent. 

Pay extra on your student loans

Depending on your situation, there may be opportunities to pay down your student loans faster than your current repayment plan. In particular, creating a budget and cutting back on discretionary expenses can make more room for extra monthly student loan payments. 

You can also look for opportunities to increase your income. For example, you may consider asking for overtime hours or a raise from your current employer or hit the job market to see if you can find a better-paying job.

You can also look into potential side hustles, such as driving for a rideshare or food delivery company, finding side gigs on Craigslist or TaskRabbit or turning a hobby into a business. 

Ask the expert

Chloe Moore

CFP®

I recommend saving and paying off debt simultaneously and not waiting until you’ve paid off debt to start saving. If you have multiple forms of debt, always aim to pay off high-interest consumer debt, such as credit cards and personal loans first. If you have both federal and private student loans, prioritize paying off the private loans first, as they don’t have the same borrower protections as federal student loans. 

FAQ

Can I take a 401(k) loan to repay student debt without penalty?

Yes, as long as you pay back your 401(k) loan within the allotted five-year period, you don’t have to worry about tax penalties. However, the timeframe for paying off the debt may be increased if you leave your job or get laid off, so keep that in mind before contacting your plan administrator.

Are there specific repayment terms for a 401(k) loan for student debt?

The IRS only provides loose rules for 401(k) loan payments. Over the five years, you’ll need to make sure you make substantially equal payments at least quarterly. 

However, it may make sense to simply sign up for regular payroll deductions to avoid falling behind.  

Does my age and my proximity to retirement affect whether paying off my student loans with a 401(k) loan makes sense?

A 401(k) loan is generally a bad idea, regardless of your age. If you’re younger, for instance, you stand to lose more in long-term investment gains by taking money out of your retirement plan.

You may have a less aggressive investment plan if you’re nearing retirement. But pulling money out of retirement so close to when you actually need it can potentially impact your retirement timeline.