Should you use your 401(k) to pay off your student loans?


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The cost of obtaining a post-secondary education has skyrocketed over the past few decades. According to a CNBC report, the average tuition and fees for a four-year private, nonprofit college is nearly $40,000. Students are going into more debt than ever to pay this astronomical cost. As noted in the article, Americans now owe more than $1.7 trillion for their education, and the prices aren’t going down.

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On average, bachelor’s degree holders graduate with close to $30,000 in student debt. Monthly payments for these loans can range from $100 to $300 or more. For master’s or doctoral graduates, payments can easily exceed $1,000 per month.

Without a doubt, graduates are drowning in debt. Given these harsh realities, the question becomes: should you use your 401(k) to pay off your student loans?

Facing the facts

Before withdrawing money from your 401(k), you need to know the facts. Unless you have reached retirement age (59 ½), you will likely face a penalty for withdrawing from your 401(k). As noted by the Internal Revenue Service (IRS), early distributions from a retirement plan can result in a 10% penalty, with some exceptions. You may also have to pay income (state and federal, depending on where you live) on the amount you take.

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If the weight of your student loans is overwhelming you, there may be several alternatives to consider before accepting the penalty and taxes associated with early withdrawal from your 401(k). Therefore, unless you are at serious risk of defaulting or are at least 59½ years old, using your 401(k) to pay off your student loans is not a wise choice.

Exceptions to the rule

As with everything in life, there are some exceptions to consider. For example, you may be eligible for a hardship withdrawal. A hardship distribution does not allow you to withdraw money to pay off your student loans but can be used if you have an “immediate and serious financial need”.

According to the IRS, tuition to cover your tuition and room and board costs meet the burden of immediate and heavy financial need. You can also use a hardship distribution to cover post-secondary education costs for your spouse, children, dependents, or beneficiaries.

Again, a hardship distribution cannot be used to pay off student loan debt you have already incurred, but it can be used to pay tuition for the next 12 months. In addition, some pension plans do not allow hardship distributions.

Borrow could be better

If you’re in dire financial straits but have a healthy 401(k), you might want to consider taking out a loan against your retirement plan. According to the IRS, Individual Retirement Accounts (IRAs) and IRA-based plans are not able to offer loans.

To borrow from your 401(k), you must first make sure your plan offers participant loans. Next, be sure to read the fine print. There may be a minimum and a maximum on the amount you can borrow. Typically, you can receive a loan of up to 50% of your acquired account balance, up to $50,000. Also, in most cases, you’ll have to pay off your loan within five years, which means you could have higher payments.

Weigh your options

Long story short: before taking the penalty, consider other options rather than withdrawing from your 401(k). Even if it’s healthy, you’ll be doing yourself a disservice. Not only will you pay dearly to withdraw the money, but you will also lose potential winnings. You will lose compound interest which will transform your modest sum into a large nest egg when you retire.

Consider the alternatives

Now that you understand why it’s not advisable to withdraw from your 401(k) early to pay off your student loans, let’s discuss other ways to pay off your loans. Depending on the type of loan you have, you can request forbearance or forgiveness. State and federal programs can help you write off outstanding debt, especially if you’ve chosen a career in public service.

If you have high federal student loans relative to your income, you may qualify for an “income-oriented repayment plan.” An income-oriented repayment plan can significantly reduce your student loan.

You can also contact your lender directly to see if they will work with you on the payments. Explain why you need a loan deferral and be prepared to back it up. If you took out a private loan with a high interest rate, you might consider refinancing. All of these options may be preferable given the negative short- and long-term impact of withdrawing your 401(k) early.

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This article originally appeared on Should you use your 401(k) to pay off your student loans?


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