If you’re one of the 44 million Americans who currently hold a portion of the country’s $1.5 trillion
student debt , chances are you’ve got student loans on the brain. The average student graduates with just over $37,000 in student loan debt.
Paying off that much debt is an impressive feat which takes discipline and commitment. If you’re currently living under the heavy weight of your student loans, you may have considered using your 401(k) for student loans. But should you really cash out your 401(k) for student loans?
It probably goes without saying that figuring out how you’re going to pay off your student loans is overwhelming—and there isn’t one definitive solution. And while it’s certainly tempting to just take the cash from your 401(k) and pay off a high-interest loan, there are some serious drawbacks to consider before running with that plan.
Options for Using Your 401(k) to Pay Off Debt
Before you make any moves, you’ll need to determine how much you are eligible to withdraw from your 401(k), and what penalties and taxes you would encounter. In most cases, you would be responsible for a 10% penalty and regular income taxes on a withdrawal from your 401(k) prior to age 59 ½.
There are a few exceptions to this rule. For instance, if you were laid off you may be able to withdraw money penalty-free as long as certain requirements are met.
And depending on the exact terms of your 401(k) plan, you may be able to withdraw the money from your plan without penalty in certain hardship situations —like to cover tuition or medical expenses.
If you already attended college and are trying to use your 401(k) to pay back student loans, that doesn’t qualify for a hardship withdrawal . If you’re not sure what the details of your plan entail, it’s worth contacting your HR representative or the financial firm that handles your company’s 401(k) program.
Using money from your 401(k) to pay off debt can be a risky proposition. While on the bright side it would potentially allow you to eliminate your student debt, it also puts your retirement savings at risk.
When it comes to using your 401(k) to pay off your student loans, there are a couple of options to consider.
Depending on your circumstances you might be considering cashing out your entire 401(k). Alternatively, however, you could borrow against your 401(k) by taking out a 401(k) loan. Here’s a bit more info about those two options.
Cashing Out Your 401(k)
Withdrawing money from your 401(k) can seem like a tempting idea when your student loan payments are causing you to stress at the moment and retirement feels like it’s ages away.
But making an early withdrawal comes with penalties. If you withdraw your money prior to the age of 59 ½ you’ll pay a 10% penalty on the amount you withdraw, in addition to regular income tax on the distribution itself. In addition to the taxes and the early withdrawal penalty, money that you withdraw loses valuable time to grow between now and retirement. That is why, as mentioned, simply withdrawing money from a 401(k) very rarely makes sense, when you consider the taxes, penalties, and lost growth.
To reinforce this point, let’s consider a (completely hypothetical) person in the 22% income tax bracket who has $13,600 left on their student loans. (And remember, this is just an example—and there are many other factors that can come into play, but this should give you a high-level glimpse into why withdrawing cash from your 401(k) might not be the best call.)
If this person cashed out $20,000 from their 401(k), they would actually receive $13,600 after paying federal income taxes and penalties. Additionally, depending on their state, they might also pay state income taxes, let’s not get bogged down on that right now.
Assuming they used that money to pay off their student loans (at a hypothetical 5% interest rate with five years left on the loan), they would have saved roughly $1,798.93 on interest.
So essentially, this person would have incurred $6,400 in penalties and taxes in order to save $1,798.93 in interest. That’s why cashing out a 401(k) to pay off student loan debt might not be a great idea.
And if they had simply let that money grow in their 401(k) over the next five years, that $20,000 could have grown to more than $28,000. P.S., that’s assuming a 7% rate of return on our fictional borrower’s 401(k).
Borrowing from Your 401(k)
When you borrow money from your own 401(k) , it technically isn’t a loan since there is no lender (aside from yourself) or review of your credit history. Instead, you are accessing your retirement funds and then paying them back, with interest, in an attempt to replenish your savings.
Not all companies offer 401(k) loans, so it’s important to check with your employer to confirm if the option is available to you. (And for the record, you can’t take out a loan from an employer-sponsored 401(k) if you’re no longer with that employer.)
In addition to the rules determined by your employer, the IRS sets limits on 401(k) loans as well. The current maximum loan amount as determined by the IRS is 50% of your vested balance , or $50,000—whichever is less. If you have a balance of less than $10,000, you may be able to borrow up to $10,000.
The IRS also requires that the money borrowed from your 401(k) be paid back within five years based on a payment plan that is established when you borrow the money. There is an exception; if you bought a house with the money you withdraw, you may be able to extend the repayment plan.
Note that if you change jobs, your 401(k) plan will roll over, but not your loan. Which means you’ll face an accelerated payment plan to repay the unpaid balance of the loan. Interest rates are usually set by your plan administrator . A 401(k) loan typically offers a relatively low interest rate and doesn’t require a credit check (since you’re borrowing against yourself), so it could be a viable option for those interested in securing a lower interest rate for their debt but who don’t qualify for student loan refinancing due to their credit history or other factors.
It should be noted, however, that those with federal student loans could also consolidate with a Direct Consolidation Loan. A Direct Consolidation Loan allows borrowers to bundle their federal loans into one—and their interest rate becomes the weighted average of the combined loans’ rates, rounded up to the nearest eighth of a percent. While refinancing with a private lender means forfeiting federal loan benefits, consolidating with a Direct Consolidation Loan means retaining your access to a lot of those benefits.
You may want to crunch some numbers and compare the interest rates on your student loans with the interest rate on a 401(k) loan before you commit to this course of action.
If your student loan interest rate is lower than the potential interest rate on your 401(k) loan, it could make sense to keep your retirement savings intact.
The other factor to consider is the missed growth on the money you borrow from your 401(k), which is why 401(k) loans could make more sense for high-interest debt such as personal loans or credit cards but are typically less ideal for low-interest debt such as student loans or mortgages.
While a hardship withdrawal won’t be an option if you are looking to pay off your student loans, it could be worth considering if you are planning on attending graduate school or are assisting a family member with their college education.
To qualify for a hardship withdrawal, you must meet certain criteria. You must prove your need is immediate and heavy. Tuition for the school year usually qualifies as immediate .
Student loan repayment wouldn’t qualify because they provide a repayment plan over a set period of time. You must also prove the expense is heavy. Usually, that means things like college tuition, a down payment on a primary residence, or a qualifying medical expense that is 10% or more of your adjusted gross income.
The Pros & Cons of Using Your 401(k) to Pay Off Your Student Loans
The obvious potential benefit of using your 401(k) to pay off student loans is that in doing so, you’ll become student loan debt free. But as we mentioned several times already, and it bears repeating, withdrawing money from your 401(k) generally means paying a penalty on money you worked hard to earn.
And the penalties you pay won’t go toward your retirement or student loans—it’s essentially lost money. So think carefully about withdrawing money from your 401(k). It is a personal decision and one that shouldn’t be taken lightly.
When deciding whether or not to withdraw money from your retirement savings, it’s important to note that while you borrow loans for other expenses in life, there’s no such thing as a “retirement loan.” You’re responsible for ensuring you have enough money to live on in retirement.
While it can feel like student loans are preventing you from living your life or meeting your financial goals in the near-term, saving for retirement can be a valuable investment in your future.
Alternatives to Help Control Your Student Loan Debt
If you’re struggling with student loan payments, don’t feel paralyzed. Borrowing money from your 401(k) isn’t the only option available to you. There are alternatives that can help you get your student loan debt under control while keeping your retirement savings intact. One option that could provide some relief to borrowers who are strapped for cash is student loan refinancing.
When you refinance your student loans you’ll take out a brand new loan from a private lender, who will review your credit history and other financial factors to determine how much they will lend to you and at what rate.
With a solid financial picture and credit history, you can stand to lower your interest rate—meaning you could reduce the amount of money you spend in interest over the life of the loan (depending on the loan term, of course).
You could also lower your monthly payments by extending the length of the loan term, which would ultimately mean you spend more money in interest over the life of the loan, but could help free up some cash flow more immediately.
However, it’s important to remember that refinancing with a private lender means you’ll lose access to federal loan benefits like income-driven repayment plans, forbearance, and deferment.
To help you decide if refinancing is a good idea, take a look at SoFi’s student loan payoff calculator to see when you might pay off your current loans. Then compare that with a potential new loan—you may be surprised at how much of a difference refinancing can make. And with more wiggle room in your budget, you could make headway toward student loan repayment and save for a retirement you’ll be able to enjoy.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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SoFi Student Loan Refinance
IF YOU ARE LOOKING TO REFINANCE FEDERAL STUDENT LOANS PLEASE BE AWARE OF RECENT LEGISLATIVE CHANGES THAT HAVE SUSPENDED ALL FEDERAL STUDENT LOAN PAYMENTS AND WAIVED INTEREST CHARGES ON FEDERALLY HELD LOANS UNTIL THE END OF SEPTEMBER DUE TO COVID-19. PLEASE CAREFULLY CONSIDER THESE CHANGES BEFORE REFINANCING FEDERALLY HELD LOANS WITH SOFI, SINCE IN DOING SO YOU WILL NO LONGER QUALIFY FOR THE FEDERAL LOAN PAYMENT SUSPENSION, INTEREST WAIVER, OR ANY OTHER CURRENT OR FUTURE BENEFITS APPLICABLE TO FEDERAL LOANS. CLICK HERE FOR MORE INFORMATION.
Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income-Driven Repayment plans, including Income-Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.