Retirement may seem so far away that diving into 401 (k) fund is tempting. Especially if you have a ton of student loan debt weighing on your budget. But it’s not a strategy that experts generally recommend.
Why isn’t it a good idea to use my 401 (k) to pay off student loans?
Withdrawing money from retirement accounts before reaching retirement age (hint: it’s 59½) usually has costly consequences, like …
Early withdrawal penalties
The IRS will charge a 10% penalty on any money you withdraw from your 401 (k) before you are 59 and a half. Yes, Uncle Sam celebrates half birthdays. So, paying off the average student loan debt balance of almost $ 39,000 would cost you around $ 3,900 in fees – if you’re even allowed to access the money.
“Before you start planning to withdraw money from Pension saving, I recommend that you first check with the administrator of your 401 (k) plan to confirm that a premature withdrawal is something they would allow you to do, ”says Lauren Anastasio, Certified Financial Planner and Chief Financial Officer. financial advice to the Stash investment app. In some cases, you have to quit your job or take out a 401 (k) loan (we’ll talk about that later) to get your money.
Ready for some exceptions? There are some ways to avoid paying the 10% penalty for early withdrawal. One is the “Rule of 55,” which says you can withdraw money from your 401 (k) without penalty if: 1) you quit a job in the same calendar year that you turn 55 or more, and 2) you withdraw the money from your last employer. You can also ignore the penalty if you are or become totally and permanently disabled. Or if you die.
Another possible solution to avoid the penalty: If you’re facing a qualifying financial emergency – think about high medical bills or foreclosure or eviction, but not student loan debt – you could take a withdrawal of proofs to cover what you need now. Whether this is allowed is up to the administrator of your plan. If this is the case, you must prove your difficulties and prove that the 10% penalty does not have to apply.
Even with these exceptions, you will still have to pay …
The IRS treats early withdrawals from your 401 (k) as income. This means that you will owe taxes on the total amount of your withdrawal for that tax year. Some states add an additional tax on what you withdraw. And keep in mind that your tax rates are usually higher when you work. So you could pay more taxes today than when you retire.
One of the main reasons to build your 401 (k) early is to let compound returns do their job: grow your wealth. Withdrawing that money to pay off your student loans means reducing your time in the market. And potentially lose earnings that are probably more than the student loan interest you could have saved. Because the returns on investment tend to be higher (on average) than the rate you pay on college debt.
What if I borrowed instead of my 401 (k)?
Some companies allow employees to take out loans on their 401 (k) s. “In many cases, it is easier and more advantageous from a tax point of view than to make a premature withdrawal”, explains Anastasio.
This strategy has certain advantages. A 401 (k) loan does not require a credit check or does not appear on your credit report. It also comes with low interest rates (which you pay to yourself, not to a bank anyway). And there are no tax consequences, as long as you pay back the money on time.
There are also downsides. You often have to pay an “original fee” of up to $ 75, and sometimes an additional maintenance fee. Typically, you have a maximum of five years to repay the loan. After that, be prepared for penalties and taxes on the remaining balance. If you leave your employer before the loan is repaid, your balance is due immediately. This means that it is risky to use a 401 (k) loan to pay off student loans if you don’t have job security. And again, you’ll miss out on those years of tax-deferred compound returns that might be hard to catch up on later.
It should also be noted that student loans granted by the federal government come with benefits and protections that other debts do not. Think about: postponement and abstention options, income-based repayment plans, and even loan remission. Replacing your student loans with debt in the form of a 401 (k) loan would eliminate these benefits. And would not actually reduce the amount of debt you owe.
When can Am I using my 401 (k) money?
Ideally, retired. Once you reach retirement age, you are free to start withdrawing money without paying penalties. But you will probably have to pay income taxes, unless it is a Roth account. When you turn 72, you should start making regular withdrawals, ie “minimum distributions required”.
What is the best option for repay my student loans?
It will depend on whether you have federal or private loans.
If you have federal loans …
Anastasio says you should inquire about the possibility of an income-based repayment plan, deferral, or if other payment modification options are available. You could also get student loan forgiveness, if you have a qualifying job or if it is part of your income-based repayment plan. Don’t count on it coming from the government.
If you have private loans …
Look into refinancing. Getting a lower interest rate can help you lower your monthly payments and to save money overtime. You can also consolidate your debt with a personal loan if your student loan rates are higher. But change isn’t always good, so make sure refinancing is right for you before you travel.
Another possibility, courtesy of the SECURE Act: If you are a beneficiary of a 529 plan, the account holder can withdraw up to $ 10,000 to use to pay off your debt, without penalty or federal tax.
Getting rid of your crushing student loan debt can seem a lot more urgent than (maybe) someday retiring. But using a 401 (k) to pay off student loans is almost never worth the cost, now or later. You have better options to explore first when it comes to getting your student debt under control.
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Skimm’d by Casey Bond, Liz Knueven, Stacy Rapacon and Elyse Steinhaus