401 K for Student Loan: Why You Shouldn’t Use 401(K) to Pay It Off

401(K) for Student Loan: A 401(k) is a retirement savings plan offered by many for-profit companies. If you’re hoping to pay off student loans with your 401(k), there are several downsides to consider.

Why You Shouldn't Use 401(K) to Pay off Student Loan

If you owe money on student loans and have cash just sitting in a 401(k); it might be tempting to take a loan from your retirement account to pay down your educational debt.

Although there are some advantages to this approach, the cons typically far outweigh any potential benefits. Taking a loan from a 401(k) is a big risk that could end up hurting your financial future.

This approach could also mean giving up important protections available to student loan borrowers. Because of these big downsides, it’s often best to find other ways to deal with student debt if it’s causing you frustration.

401(k) in Details

Withdrawing money from a 401(k) to pay student loans is almost always a terrible idea; this is because taking money out of your retirement account before you’re 10 percent on withdrawn funds.

Rather than withdrawing cash; you could tap into your retirement savings to repay student debt by borrowing money from your 401(k). You’d have to pay principal and interest on your 401(k) loan; but would be paying the money back to your own retirement account instead of enriching a lender.

When you borrow from a 401(k), repayment terms are determined based on how much you borrow. Your plan can set its own interest rate and you must repay the entire balance within five years.

You can use the money for anything you’d like, so you could borrow from your 401(k) to pay off federal or private student loans.

Benefits

The big benefit of a 401(k) loan is that you get to pay interest to yourself instead of to a student loan lender. But, this might not necessarily be as attractive a prospect as it seems because there’s an opportunity cost to not having your money invested. You miss out on returns you’d have earned if you left the money in your 401(k).

If your student loans charge 6 percent interest per year in interest and you could’ve gotten an 8 percent return on invested funds over the course of the year, you’d be worse off than if you’d left your money in the 401(k) and just paid interest to your student loan lender.

Risks of Borrowing From a 401(k) to Repay Student Loan

Risks of Borrowing From a 401(k) to Repay Student Loans

There are ample risks associated with borrowing from a 401(k) to repay student debt:

  • If you don’t make payments, you could default and owe a 10 percent penalty on your outstanding loan balance.
  • If you can’t pay the loan back within five years, you could owe a 10 percent penalty.
  • When you leave your job and can’t repay the loan very quickly, you could owe a 10 percent penalty.
  • You’ll lose borrower protections including access to income-based payment programs, Public Service Loan Forgiveness, deferment, and forbearance.
  • You’ll miss out on investment gains during the time your money is withdrawn.

Why You Shouldn’t Pay Off Debt Using Retirement Savings

A 401(k) is a great way to save for retirement because it offers significant tax savings. You can put in money directly from your paycheck before taxes are withdrawn, which reduces your taxable income. That means you will pay less in taxes each year.

But if you withdraw your funds early, you’ll typically face consequences. Generally, IRS you to start pulling money out of your 401(k) without penalty starting at age 59 ½, and you’re required to start taking withdrawals at age 70 ½.

If you dip into your 401(k) before that age, you’ll likely owe both federal income tax and a 10% penalty on the amount that you withdraw. You may be on the hook for state income taxes, too.

Alternatives for Repaying Student Loans

The good news is, you have other options if you’re tired of making big monthly payments and feeling like you’re getting nowhere.

Options to consider include:

  • Refinancing student loan debt: Many borrowers can reduce the interest they pay on student loans by refinancing with a new lender. While this also means giving up borrower protections associated with federal loans, you aren’t putting your retirement at risk – and could potentially cut interest costs substantially. When you refinance, you can consolidate both federal and private loans together.
  • Consolidating federal student loan debt: Only federal student loans are eligible to be consolidated with the government, and your interest rate won’t change – but you can combine multiple loans into one big one. You can potentially reduce your monthly payment, too, as consolidation might offer longer repayment terms. Although your loans would cost more in interest in the long run if you stretched out the repayment timeline. Learn more in our Direct Consolidation Loan guide.
  • Paying extra to existing student loans: If you can work a side gig or find room in your budget to pay extra, you could pay off student loans faster.

Final Thought

Alternatives for Repaying Student Loans

Borrowing from your 401(k), if your employer allows, can be an alternative to taking out a student loan although it’s important to weigh the pros and cons before doing so. If you have an IRA, you can make a withdrawal penalty free for qualified education expenses at an eligible institution.

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