If retirement feels far away, it might be tempting to use your 401(k) to pay off student loans. But using retirement funds to pay your education debt is a risky idea. Not only could you rack up substantial penalties and fees from taking early withdrawals, but you’ll also be taking away from the retirement savings you’ll need in the future.
Instead of withdrawing from your 401(k), you might be better off using alternative strategies to manage your student loans, such as applying for income-driven repayment or refinancing to a lower rate.
If you owe a lot in student loans, withdrawing funds from your 401(k) to pay them off may seem like a simple solution. After all, you can refocus on saving for retirement after your student loans are gone, right?
Not so fast — there are a few potential flaws to this plan. For one, withdrawing from your 401(k) before you’re 59½ years old can trigger a 10% penalty fee. Plus, you’ll likely have to pay income taxes on the distribution, as well as state taxes if you’re subject to them.
“It’s honestly not something that you should consider,” says Robert Farrington, student loan expert and founder of The College Investor.
Besides losing money to penalties and taxes, you’ll also miss out on the investment earnings you could have made by keeping your money in your 401(k). The longer your money stays invested, the more you can earn due to compounding interest.
“Student loan debt can feel like a burden, but it’s better to save for your future and let your money grow and compound than to pull out your money early to pay off your loans,” says Farrington.
By withdrawing from your 401(k) early, you’ll miss out on this compounding interest effect and have less money saved when you want to retire.
| Note: There are a few exceptions to these rules. If you have a Roth 401(k), you can withdraw your contributions fee- and tax-free anytime (since you already paid taxes on the amount). Withdrawing your earnings early, however, will trigger a penalty. And for a traditional 401(k), individuals who are 55 or about to turn 55 and have left their job can withdraw without the 10% penalty in some cases. This is known as the Rule of 55. |
If you’re facing a financial emergency, you may be able to take a hardship withdrawal from your 401(k) without incurring the 10% penalty. However, you’ll still have to pay income taxes on the amount you take out.
The IRS allows hardship withdrawals for “an immediate and heavy financial need.” In some circumstances, you could use your 401(k) hardship withdrawal to pay for college tuition. Medical expenses or an imminent home foreclosure also usually qualify.
However, you can’t take a hardship withdrawal to repay student loans. Even if you’re struggling to keep up with your monthly payments, you’ll have to look to alternative strategies to ease the burden.
Withdrawing from your 401(k) before you’re 59½ is tricky due to penalties and taxes. However, some employers give you the option of borrowing from your account with a 401(k) loan.
If your employer permits it, you could take out a loan of up to 50% of your vested balance or $50,000, whichever is less. You won’t pay taxes or a withdrawal penalty, but you’ll have to pay back what you borrowed plus interest, usually within five years.
The loan interest you pay will go into your 401(k), helping offset your lost earnings. However, borrowing from your 401(k) could still endanger your overall return on investment. For example, if you pay a low-interest rate on your 401(k) loan, you may have been able to earn more by leaving the money invested instead.
Plus, you could have to pay the loan back in full immediately if you lose your job or switch employers. If you default on the loan, it will be treated as a withdrawal, and you’ll be subject to taxes and the 10% penalty if you’re under the age limit.
While 401(k)s are employer-sponsored retirement plans, nearly anyone can open an IRA account on their own. The rules for early withdrawals are similar, but you’re allowed to take out your money for qualified education expenses.
For instance, you’re allowed to withdraw from your IRA early to pay for tuition and fees, school supplies, and equipment. Student loans, however, don’t count as qualified education expenses.
If you’re using your IRA to pay off student loans, you could rack up a 10% penalty plus applicable income taxes (unless you’re 59½ or older). A Roth IRA allows you to withdraw your post-tax contributions at any time, but taking out your earnings early will trigger the penalty and tax obligation.
Plus, you might not have enough saved once you’re ready to retire. “It’s much better to let the money in your IRA grow for the long term than to pull it out early for your loans,” says Farrington.
Instead of pulling from your retirement savings to pay off student loans, consider these alternative debt repayment strategies:
Related: Learn more about refinancing your student loans