The temptation is definitely there. You have thousands of dollars set aside for retirement. Even when the stock market does well, it barely keeps pace with the interest rates on your student loans. Why not empty the 401(k), pay off the student loans, and start with a fresh slate?
Where you are staring down the barrel of massive student debt, such a desperate act might seem like the smart move. The math tells a different story.
The Consequences of using 401(k) funds to pay down debt
The nice thing about a 401(k) is that you can put money in the account without being taxed. This allows savers the opportunity to more quickly accumulate wealth. However, the flip side of this coin is that when you pull money out, it is taxed. That means that 30k in your retirement account will not pay off 30k in student debt.
Making the decision not to touch the money even easier is the fact that there is a huge penalty for dipping into the 401(k) before you reach retirement age. Before turning 59 and half, withdrawals from the 401(k) are taxed at an additional 10%. This is the early withdrawal penalty. While there are a couple exceptions, student loans are not one of them.
Should I put less in my 401(k) and more towards my student loans?
If you have made the decision not to touch your 401(k), it is tempting to just save a little less and use the diverted funds towards paying down student debt.
The analysis here is not a clear cut.
The first part of your investigation into this decision should be to determine if your employer is matching your contributions. If you are lucky enough to have matching contributions in any form, you will come out ahead financially if you maximize the employer match.
When your employer isn’t matching your contributions, you have to weigh the short-term and long-term budget issues as well as the tax consequences of your decision. We have discussed this analysis in prior articles.
Finally, the math gets especially complicated for federal borrowers on income driven repayment plans. If you are making contributions to your 401(k), your adjusted gross income is lowered at tax time. The lower AGI means lower payments on plans such as IBR, PAYE, and REPAYE. Thus, the more you save for retirement, the lower your federal student loan payments will be.
The one item that can really alter your analysis will be late fees and the costs associated with defaulting on your loan. If you cannot make minimum payments on your loans, it might make sense to place a lower priority on your retirement account and focus on the immediate crisis.
Desperation to pay off student debt is usually a good thing. It encourages responsible budgeting and helps you prioritize your spending. Where desperation gets dangerous is when it leads to ill-advised decisions. Don’t let your desperation to eliminate student debt force you into a dumb 401(k) decision.