Should You Pay Off Student Loans With Your 401k?
If you're hoping to pay off student loans with your 401(k), there are several downsides to consider. The tax implications, as well as the potential for penalties and loss of returns are only some of the big things to keep in mind with this strategy.
If you owe money on student loans and have cash just sitting in a 401(k), it might be tempting to take a loan from your retirement account to pay down your educational debt. If your plan allows loans, you can borrow the lesser of $50,000 or 50 percent of your vested 401(k) balance to pay off student debt – and you’ll be making payments to yourself rather than a lender if you do.
Although there are some advantages to this approach, the cons typically far outweigh any potential benefits. Taking a loan from a 401(k) is a big risk that could end up hurting your financial future.
This approach could also mean giving up important protections available to student loan borrowers. Because of these big downsides, it’s often best to find other ways to deal with student debt if it’s causing you frustration.
On this page:
- How Does a 401(k) Loan Work?
- What to Consider Before Using a 401(k) Loan
- Alternatives to Repaying Student Loans
How Does a 401(k) Loan Work?
Withdrawing money from a 401(k) to pay student loans is almost always a terrible idea because taking money out of your retirement account before you’re 59½ can trigger a 10 percent penalty on withdrawn funds. This penalty is charged in addition to income tax you’d owe on the money taken out of your account.
Rather than withdrawing cash, you could tap into your retirement savings to repay student debt by borrowing money from your 401(k). You’d have to pay principal and interest on your 401(k) loan, but would be paying the money back to your own retirement account instead of enriching a lender.
When you borrow from a 401(k), repayment terms are determined based on how much you borrow. Your plan can set its own interest rate and you must repay the entire balance within five years.
What to Consider Before Using a 401(k) Loan to Repay Student Debt
Paying interest to yourself instead of to a student loan servicer probably sounds pretty great. But there are a few big things to consider before you decide a 401(k) loan is the right approach to getting free of student debt.
First and foremost, if you think you might leave your job, taking a 401(k) loan can be a bad idea because you’ll have to pay back the loan in full very quickly. Typically, if you quit or are fired, you have just 30 to 60 days to repay the entire loan balance. If you don’t have the cash – and chances are you probably don’t – you could end up being hit with a 10 percent penalty for early withdrawal.
If you’re considering a 401(k) loan to pay off federal student loans, you’ll also have to give up a lot of important borrower protections. You could miss out on the possibility of having part of your loan balance forgiven, for example. Forgiveness is possible with federal loans if you’re eligible for Public Service Loan Forgiveness or after making enough payments on an income-driven repayment plan.
And, interest on a 401(k) loan isn’t tax deductible, whereas most borrowers are eligible to take a tax deduction for student loan interest.
You can also pause payments on federal student loan debt through deferment or forbearance, but can’t just stop paying on a 401(k) loan if you return to school or experience financial hardship. In fact, if you default on a 401(k) loan by not making a regular payment, the outstanding loan balance is counted as a distribution and you’ll face a 10 percent penalty on the amount you owe.
Benefits of a 401(k) Loan to Repay Student Debt
The big benefit of a 401(k) loan is that you get to pay interest to yourself instead of to a student loan lender. But, this might not necessarily be as attractive a prospect as it seems because there’s an opportunity cost to not having your money invested. You miss out on returns you’d have earned if you left the money in your 401(k).
If your student loans charge 6 percent interest per year in interest and you could’ve gotten an 8 percent return on invested funds over the course of the year, you’d be worse off than if you’d left your money in the 401(k) and just paid interest to your student loan lender.
Risks of Borrowing From a 401(k) to Repay Student Loans
There are ample risks associated with borrowing from a 401(k) to repay student debt:
- If you don’t make payments, you could default and owe a 10 percent penalty on your outstanding loan balance.
- If you can’t pay the loan back within five years, you could owe a 10 percent penalty.
- If you leave your job and can’t repay the loan very quickly, you could owe a 10 percent penalty.
- You’ll lose borrower protections including access to income-based payment programs, Public Service Loan Forgiveness, deferment, and forbearance.
- You’ll miss out on investment gains during the time your money is withdrawn.
There’s also another big downside. When you repay your 401(k) loan, you pay interest with after-tax funds. But when you withdraw money during retirement, there’s no distinction made between pre-tax contributions and interest paid with after-tax dollars. You’ll be taxed on all your withdraws, so you pay taxes on the money twice: when it comes out and when you put it in to pay your loans.
Alternatives for Repaying Student Loans
Convinced yet that a 401(k) loan isn’t the right approach to repay student debt? The good news is, you have other options if you’re tired of making big monthly payments and feeling like you’re getting nowhere. Options to consider include:
- Refinancing student loan debt: Many borrowers can reduce the interest they pay on student loans by refinancing with a new lender. While this also means giving up borrower protections associated with federal loans, you aren’t putting your retirement at risk – and could potentially cut interest costs substantially.
- Consolidating student loan debt: Only certain student loans are eligible to be consolidated, and your interest rate won’t change – but you can combine multiple loans into one big one. You can potentially reduce your monthly payment, too, as consolidation might offer longer repayment terms. Although your loans would cost more in interest in the long run if you stretched out the repayment timeline.
- Paying extra to existing student loans: If you can work a side gig or find room in your budget to pay extra, you could pay off student loans faster.
Taking a 401(k) loan is a risky approach to repaying student debt, and the disadvantages typically outweigh any advantages. Consider alternatives such as refinancing your debt if you’re tired of paying a substantial amount of student loan interest and you want to get your loans repaid ASAP without jeopardizing your retirement security.
Author: Christy Rakoczy
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