Here’s Why You Should Avoid Using Your 401(k) to Pay Off Student Loans

The student loan crisis is about to hit a new tragic milestone with 1 million borrowers owing more than $200,000 of student debt. With so many graduates carrying around debt loads that are often more than a mortgage, some borrowers might be considering using their 401(k) to pay off student loans.

There’s a big push within the financial community to pay off debt, including student loans, with a hyper-focused intensity. This can sometimes result in people choosing to tap into their retirement savings because they feel a sense of urgency to eliminate their student debt. Plus, retirement can seem like a lifetime away for young professionals.

However, in most cases, early withdrawal of your 401(k) plan can be costly and have lasting effects into retirement age. Fortunately, there are many alternative options to help you pay off your student loans.

Here’s what you need to know if you’re considering using your 401(k) to pay off student loans.

Pros and cons: Using your 401(k) to pay off student loans

Sure, you can use your 401(k) to pay student loans, but that doesn’t mean you should. A 401(k) plan is designed for use in retirement age (e.g. after the age of 59½). In most cases, you’ll be penalized for making an early withdrawal.

There are special circumstances where you can withdraw 401(k) funds penalty-free, such as when you have an “immediate and heavy financial need” or if you’ve been affected by the COVID-19 pandemic.

Common scenarios that might qualify for penalty-free withdrawal (depending on your plan) include medical care expenses, costs related to purchasing your primary home, funeral expenses and college tuition costs.

Since student loans don’t make the cut, you’ll need to weigh the pros and cons of using your 401(k) to pay off student loans.

Pros of using your 401(k) to pay student loans

If you choose to pay off your student loans using your 401(k) funds, you’ll have immediate access to the money. You can then make a lump-sum payment and be done with your student loans for good. That alone can be a huge mental and financial weight lifted.

You also won’t accrue interest on your student debt, and you won’t have a monthly student loan payment anymore. So, you can immediately reduce your current monthly expenses by eliminating your student loans.

Cons of using retirement savings early

Although there are some potential positives for using your 401(k) to pay off student loans, there are far more heavy negatives. For most early 401(k) withdrawals, you’ll incur a 10% penalty and have to pay income taxes on the amount distributed.

This means if you withdraw $50,000 to pay off your student loans, you can expect to pay a $5,000 penalty when it’s time to file your tax return. But you’ll also have to pay federal (and possibly state) taxes on the $50,000 distribution since contributions to a 401(k) are tax-deferred. The IRS generally requires withholding 20% of the early withdrawal amount, which in this case, comes out to $10,000. But your actual tax liability will depend on a number of factors, so you could receive a tax refund or end up owing more on the distribution.

In plain terms, that’s a total of $15,000 down the drain for the year that you take out the $50,000 401(k) early distribution.

As for long-term effects, you’re going to miss out on compounding interest opportunities, which significantly slows your financial growth for retirement.

Tapping into your retirement savings for non-retirement needs can also become a slippery slope. Making one, two or even three early withdrawals might not seem like a lot. But those short-sighted financial decisions eventually become detrimental to your future self.

Student loan payoff alternatives

There are many alternative options to using your 401(k) to pay off student loans. Therefore, it should be a last resort. Explore the following student loan payoff strategies to determine which option fits your unique situation.

• Refinance your student debt. If you have private or federal student loans, it’s likely you can lower your interest rate by refinancing your student debt. Refinancing can reduce your monthly payments and help you pay off your balance faster. You might even be able to score a generous cash-back bonus!
• Change your repayment plan. If you can’t afford your current federal monthly payment, consider enrolling in an income-driven repayment (IDR) plan. Your payments will be capped at 10% to 20% of your discretionary income, depending on the plan. You’ll also be eligible for IDR loan forgiveness after 20 to 25 years of payments.
• Explore available loan forgiveness programs. Do you work for a government or nonprofit employer? If so, you might be eligible for Public Service Loan Forgiveness (PSLF), which wipes away your federal loan balance after 10 years of qualifying payments. Even if you aren’t eligible for PSLF, you might still qualify for other loan forgiveness programs specific to your state or profession.
• Use your Roth IRA contributions. Early withdrawals from a traditional IRA result in the same outcomes as taking funds from your 401(k). But if you have a Roth IRA, you can make penalty-free and tax-free withdrawals of your contributions (not any gains) before the age of 59½. Roth IRA distributions are treated differently because you’ve already paid income taxes on those dollars. But again, there are long-term consequences to reducing your overall retirement savings and losing out on compounding interest.
• Create a student loan repayment plan. Our student debt experts can create a custom plan that factors in your financial, personal and career goals. Whether you’re trying to pay your student loans off as fast as possible or prefer to pay as little as possible, a student debt consultation can give you clarity on your options and a strategy for maximizing your finances.

Think twice before using your 401(k) to pay off student loans

The truth is you have plenty of time and opportunities to pay off your student loans. But your retirement funds need time to grow to provide you with a comfortable lifestyle come retirement age.

Even if retirement seems like a long way away, we recommend focusing on maxing out your 401(k) before tackling your student debt. This helps lower your adjusted gross income, which in turn, lowers your tax bill and federal student loan payment if you’re on an IDR plan. At minimum, make sure you’re taking advantage of any 401(k) company match.

Once those funds hit your 401(k) account, don’t touch them until retirement or until you absolutely need them for an extenuating circumstance.

Bottom line is this: Avoid using your 401(k) to pay off student loans because it can do more financial harm than good in the short- and long-term.