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Can You use your 401k to pay off student loans?

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401k For Student Loan Repayment

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.

Table of Contents
Taxes And Penalties If You Use Your 401k For Student Loan Repayment
Withdrawing Money Early Has A Huge Opportunity Cost
Ways To Avoid Penalties and Taxes
Alternative Student Loan Payoff Strategies
Final Thoughts

Taxes And Penalties If You Use Your 401k For Student Loan Repayment

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 If she withdraws $50,000 from her 401(k) she’ll pay a $5,000 penalty plus 24% taxes on the full $50,000 amount withdrawn.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.

Withdrawing Money Early Has 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.

Ways To Avoid Penalties and Taxes

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.

  • Find an employer who offers to match student loan payments with 401(k) contributions. The SECURE Act 2.0 was signed into law at the end of 2022. It allows employers to contribute to a 401(k) when an employee makes payments to their student loans. If you’ve got a high student loan balance, you may want to choose an employer who offers this benefit. You can continue to attack your student loans while your employer sets aside money for your retirement.
  • Wait five years and repay loans with your Roth 401(k) contributions. A Roth 401(k) lets you contribute after-tax income, and it grows tax-free. Since you’ve already paid tax on the contributions, there are no penalties or tax implications if you withdraw the money early (as long as the money has been in the account for five years). But that doesn’t make early withdrawals a good idea. When you take money out of your 401(k), you can’t put it back in. The money that could have compounded over time, has been spent on loans.
  • Use a 401(k) loan. Many employers allow you to borrow against your 401(k). A 401(k) loan is a loan from your future self to your current self. When you borrow against your 401(k) you take money out of the market and you use the money for other expenses. Over time, you slowly repay the principal value of the loan (plus interest which you also get to keep), and your money is reinvested in the market. A 401(k) loan can certainly help you pay off your student loans, but it comes with risks. You may take a loan as the market experiences massive growth. You’ll miss out on that growth because you used the money to pay off debt. And if you lost your job, you could be required to repay the loan or face penalties.

Alternative Student Loan Payoff Strategies

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:

  • Only contribute enough to your 401(k) to get the match. Many employers offer a 50% to 100% match on all 401(k) contributions up to a certain percentage of your income. This is money that you deserve to earn because it’s part of your compensation. Contribute enough to your 401(k) to get your full match, but use the rest of your income to accelerate your debt payoff. You’ll have a bit invested for your future self while staying mostly focused on your current financial goal.
  • Use a side hustle to boost earnings. Once you have a clear financial goal like paying off student loans, a side hustle can help you achieve that goal faster. Use your side hustle money to pay off debt, so you don’t get used to living on this money. That way, when your debt is gone, you don’t have to keep hustling unless you enjoy it.
  • Try house hacking to keep your cost of living low. Cutting out the fun stuff in your life will make debt payoff hard. But there are a few ways to cut back that have residual payoffs. House hacking, or taking renters into your home or condo, can be a great way to eliminate your mortgage for a few years while you shovel more money into your debt.
  • Use a conscious spending plan. A conscious spending plan, aka a budget can help you put more money towards debt and less money towards stuff that doesn’t matter. Most people struggle to stick to a rigorous budget over the long term, but it can be a tool to help you to keep your spending in line during your debt payoff journey.

Final Thoughts

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.

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By: Hannah Rounds
Title: 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

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