Should I Use My 401(k) to Pay Off Student Loans?
Are you considering using your 401k to pay off student loans? If you’re struggling with student loan payments, it may be a tempting option. Using 401(k) to pay off student loans is possible, but not recommended. Doing so could result in losing money to fees and taxes. Continue reading to learn more about using a 401(k) to pay off student loans.
Related: How do student loans affect credit?
What is a 401(k)?
A 401(k) is a retirement savings plan. 401(k) plans are offered by American employers. A 401(k) allows part of an employee’s paycheck to be placed into an investment account. The employer that provides the plan can match some or all of the contribution. Funds in a 401(k) will increase over time because of compound interest.
Taking funds from your 401(k)
Anyone is allowed to take funds from their 401(k). However, doing so before the age of 59½ will result in a penalty of 10% of your withdrawal on your tax return. On top of that, the withdrawal will be taxed as income. So, no matter what amount you withdraw, you’ll end up losing money that could have been saved.
Additionally, withdrawing from your 401(k) before 59½ will cause you to lose any compound interest that would have been earned on those funds.
Also see: All about paying off student loans early
Borrowing funds from your 401(k)
Depending on the company that your employer uses for the 401(k), you may be able to borrow funds. Borrowing from your 401(k) is like taking out a loan, but the lender is the account. Generally, the borrowed funds must be paid back, with interest, to the account within 5 years. The limit on the amount that can be borrowed from a 401(k) is 50% of the vested account balance. Multiple loans can be taken from the account, but they can’t exceed $50,000 total.
This option is slightly better than completely removing the funds from the account because it gives you the chance to add the money back. However, you’ll still pay the 10% penalty and income tax on the loan. That money will not go toward repaying the loan. In this case you’ll also lose money that could have been saved.
Also read: Student loan default: How to get out of it
If you haven’t taken out student loans, or want to avoid taking out more, it is possible to make a hardship withdrawal from your 401(k) to pay for your education. However, a hardship withdrawal cannot be taken out for student loan payments.
In order to be able to make a hardship withdrawal to fund your education, you must show that there is absolutely no other way you could pay for it. There must be an immediate and heavy financial burden. Student loans are not an immediate expense because they can be paid over time. Tuition, on the other hand, could be considered an immediate expense.
Withdrawing from a 401(k) should be a last resort
In conclusion, using your 401k to pay off student loans is possible, not typically not advisable. Using money from your 401(k) should be a last resort. If you’re struggling to repay your loans, try applying for deferment or changing your repayment plan. You can also look into consolidating or refinancing your loans.