Should You Use Your 401(k) to Pay Off Student Loans?
If you're paying back student loans and debating using your 401(k) to do so, this article will help you evaluate and make the best decision.
Paying back student loans is no joke. Whether you’re feeling the pressure of squeezing your budget to afford the payments or you want to be done with student loans forever, there are several ways to do so. Yes, you can use your 401(k) for student loans — and for some, it looks like an attractive option, especially if you don’t have much left on your loan. However, this approach may not be the best for your financial situation in the long term.
In other words, time is what will grow your retirement nest egg, and there are plenty of options to pay back your loans. Before paying off your student loans with your 401(k), here’s a look at what you need to consider and some alternatives.
What to Consider When Using Your 401(k) to Pay Off Student Loans
Most experts generally frown upon using a 401(k) to pay off student loans because of the risks. Sure, you get to keep on top of your payment schedule and maybe get out of student loan debt sooner, but the downsides are huge.
For one, you’ll have to pay extra taxes — typically 20% of the withdrawal amount — if you withdraw your 401(k) funds before age 59.5. So if you’re 35 years old and take out $15,000 from your 401(k), you’ll have to pay $3,000 in taxes. If you’re lucky, you may see some of that money back if you end up getting a tax refund.
Not only will there be taxes, but if you withdraw money from your 401(k) before age 59.5, you usually will need to pay an extra 10% penalty to the IRS when filing your tax return. That means if you withdraw $15,000, you’ll lose out on $4,500 in taxes and penalties. In other words, that’s $4,500 less to go toward your student loans.
Perhaps the biggest downside is that you’ll have a smaller nest egg when you retire. If you take money out of your 401(k), that money can no longer be invested and allowed to grow until you reach retirement age. Think about how much $15,000 can grow in the next 20 to 30 years. It could be a difference of tens, if not hundreds, of thousands of dollars by the time you’re ready to retire.
All this to say, paying off your student loans may feel great, but in the long term, you could be paying more in taxes and paying the price of the opportunity cost of not investing the money in your retirement account.
If you want to get out of debt more quickly or are struggling to make payments, there are numerous options to pay down your student loans before you need to consider making withdrawals from your retirement account.
What to Do if You’re Struggling to Pay Student Loans
Life happens, and you’re not alone if you’re finding it hard to make your monthly student loan payments. There are several options available instead of using your 401(k), though the exact tactics will depend on the type of student loans you have.
If You’re Struggling to Pay Federal Student Loans
The good news is that until Jan. 31, 2022, the U.S. Department of Education has paused federal student loan payments. That means you currently don’t have to pay your student loans and interest isn’t accruing. Any defaulted loans are also on pause. That means you can take this time to work on your finances and get to a place where you can afford to make payments when the forbearance period is over.
If you fear you’ll still struggle to make payments by the time January rolls around, consider enrolling in an income-driven repayment plan. There are several options, so see what you may be able to qualify for. If you’re eligible, your payments will be based on your most recent income and could be as low as $0.
Granted, you won’t be able to enroll until the forbearance period is over. In the meantime, contact your student loan servicer to see what you need to do to qualify, including submitting any documentation required.
There’s still a solution if your student loans are currently in default. In this case, contact your federal loan servicer and ask about options for a student loan default resolution. Most commonly, borrowers opt for student loan consolidation and rehabilitation. Both can turn into an income-driven repayment plan, preventing you from needing to access your 401(k) funds.
If You’re Struggling to Pay Private Student Loans
The unfortunate reality is that private student loans aren’t on pause like federal student loans. That means you’re still required to make your regular monthly payments unless you’ve worked out an agreement with your lender.
The good news is that many private lenders are currently offering payment relief programs for those affected by the COVID-19 pandemic. That is in addition to any regular forbearance or deferment programs they might have. Lenders differ in their options and what they’re willing to offer borrowers, so contact yours to discuss a possible course of action.
Whether you have federal or private loans, lowering or temporarily suspending your payments offers you some much-needed breathing room financially. Take this opportunity to work on your finances to see how you can comfortably afford your payments.
Deciding Whether to Declare Bankruptcy
Successfully discharging student loans in bankruptcy is not common. Plus, you’ll have to go through an adversarial hearing, an additional proceeding that doesn’t guarantee success.
In most cases, you’ll have to prove what the courts consider an undue hardship, and your loans must already be in default. That means you’ll have to show that you can’t maintain a basic standard of living, that there’s little chance of that changing anytime soon and that you’ve done what you can to make student loan payments.
You can still declare bankruptcy and have your other debts discharged, which could give you some wiggle room to pay back your student loans (assuming they’re not discharged).
Refinance to Pay Off Your Student Loans Faster
Perhaps you aren’t having issues with your student loans but simply want to pay them off faster. In that case, you can increase your payment each month or refinance to a lower interest rate. Juno can help you find the most affordable possible rates on refinancing student loans. Juno negotiates on behalf of borrowers with partner lenders to help each student qualify for the best refinance rates they can given their financial situation.
That way, you’ll be able to save money on interest payments. The bonus is that if you make extra payments after refinancing, you can save even more and get to that debt-free life much sooner.
Sarah Li Cain
Sarah Li Cain is a finance writer and a candidate for the Accredited Financial Counselor designation whose work has appeared in places like Bankrate, Business Insider, Financial Planning Association, Investopedia, Kiplinger, and Redbook. She’s the host of Beyond The Dollar, where she and her guests have deep and honest conversations about money affects their well-being.
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