If you’re a recent college graduate with limited cash flow, paying off student loans can feel like an insurmountable task. It’s easy to feel trapped, as you feel the pressure to pay off your student loans as quickly as possible.But while eliminating your student loans is an admirable goal, some sacrifices aren't worth it. For example, if you’re considering using your 401(k) to pay off your student loans, you may want to reconsider.
In this article, we cover the various 401(k) taxes and penalties, and present some alternative ways to eliminate your student loans.
A 401(k) is a retirement account, and is meant to fund your retirement, not pay off your student loans. To ensure people use 401(k)s appropriately, there are penalties for early withdrawals. For example, you'll pay a 10% penalty on any funds you withdraw before age 59.5. When you take out $50,000, you’ll pay a $5,000 early withdrawal penalty.In addition, you must pay income tax on any withdrawals. Taking out $50,000 from your account would add $50,000 to your taxable income. Since this is “extra” income, your 401(k) withdrawal will be taxes at your highest marginal tax rate.
For example, a single person who earns $125,000 has a marginal tax rate of 24%. If she withdraws $50,000 from her 401(k) she’ll pay a $5,000 penalty plus 24% taxes on the full $50,000 amount withdrawn. That’s $12,000 in taxes.In this case, the person withdrawing $50,000 would only have $33,000 remaining to apply to their student loans. While that may be enough to pay off the average student loan balance of a 2021 graduate, it comes with a huge opportunity cost.
Even without taxes and penalties, withdrawing money from your 401(k) has massive opportunity costs. Let's say you manage to put aside $175 per month starting at age 18. You could end up with $1 million by age 62 (assuming an 8% growth rate). But by age 30, the monthly savings required to reach $1 million more than triples to $575 per month.If you remove money from your account to pay off debt, it’s as though the money was never invested. You have to increase your savings rate significantly to stay on track. The adage “time in the market beats timing the market” holds true.
Of course, paying off your student loans will give you peace of mind. But a growing 401(k) can give you increased financial security in your old age when you don’t have as much earning potential.
Most people under age 59.5 will pay taxes and penalties when they remove money from their 401(k). Thankfully, there are a few ways to avoid this penalty.
While taking money out of your 401(k) isn’t the best way to pay off student loans, there are a few things you can do to accelerate your payoff without sacrificing your future retirement. Here are a few of our favorites:
Withdrawing money from your 401(k) to pay for student loans won't be the right move for everyone, but it's nice to know that you still have options when it comes to eliminating this debt. If you're facing 401(k) withdrawal penalties and the opportunity cost of lost investment potential, I recommend starting with the alternatives mentioned above to tackle your student loan debt.
Editor: Colin Graves
Reviewed by: Robert Farrington
The post Should You Use Your 401k For Student Loan Repayment? appeared first on The College Investor.
By: Hannah RoundsTitle: Should You Use Your 401k For Student Loan Repayment?Sourced From: thecollegeinvestor.com/42661/401k-student-loan-repayment/Published Date: Fri, 02 Jun 2023 07:15:00 +0000