Many student loan borrowers are tempted by the idea of emptying their retirement account to pay off their student loans.

On the surface, raiding your 401(k) or IRA to eliminate some student debt makes sense. Retirement is far away, and student loans are a monthly headache and a constant battle against interest.

Unfortuantely, using funds from retirement accounts to knock out student loans is usually a mistake. Most borrowers are better served by finding an alternate strategy. However, there are a couple of instances where the move might make sense.

Can retirement funds from a 401(k) or IRA be used to pay off student loans?

If you have money in retirement accounts, no law prevents you from using your money to pay off your student loans.

However, just because you can make this move doesn’t mean you should.

There are three major issues with taking money out of a retirement account to knock out student debt:

• Removing money from a 401(k) or traditional IRA means paying income taxes. Contributions and growth of these accounts are not taxed, but income taxes must be paid when the money comes out.
• Early withdrawals usually trigger a penalty. In addition to income taxes, there is a 10% penalty if you are under 59.5 years of age.
• A smaller balance means less money for retirement. Turning your student loan problems into a retirement problem is often a lousy trade. Help for seniors who go broke during retirement is limited.

Early withdrawal penalty exceptions

There are several circumstances where an IRA or 401(k) early withdrawal penalty can be avoided. These exceptions include buying a first home, medical expenses, and Covid-19.

Notably, educational expenses are an eligible reason for an early withdrawal from an IRA. Unfortuantely, the educational expenses category does not include student loans. This means you can use your retirement funds to pay for your child or grandchild’s education, but if you still have student loans, you face the early withdrawal penalty.

Even if your circumstances justify a penalty-free withdrawal, it still might be a mistake to pull money out of the retirement account. A penalty-free withdrawal is a mistake when better alternatives are available.

Alternative Options

Instead of dipping into your retirement reserves, there are a couple of options that might be preferable.

Refinancing your student debt – If you have enough money in your retirement account to eliminate your student loans, the odds are pretty good that you could find a lower interest rate through student loan refinancing. One lender, Earnest, even considers retirement accounts when making lending decisions. Several lenders currently offer refinance rates below 2%. If the interest rates on your student debt are lower than what your retirement account is earning, you will come out way ahead.

401(k) loans – Many retirement providers offer the option of a 401(k) loan. The idea here is pretty simple: you borrow the money from yourself, and then you pay yourself back. This option might appeal to people who are nearing the end of their student loan repayment road. A 401(k) loan avoids both the income tax and penalty. The danger is that if you are unable to repay the loan, you will have to pay both the tax and 10% penalty.

Scaling back retirement account contributions – Rather than pulling money out of your 401(k) or IRA, it might make sense to put less money into your retirement account so that you can pay extra towards your student loans. Those that have employer matching may want to skip this alternative because it would mean passing on a valuable perk. However, if you have high-interest student loans, focusing on that debt first is a reasonable choice.

When it makes sense to use retirement accounts for a student loan payoff

There are a few circumstances where dipping into retirement accounts is a reasonable choice.

• If you have already reached age 59.5 – If you are old enough to make a penalty-free withdrawal and you feel confident about your finances heading into retirement, pulling the money out to pay down student debt makes sense.
• If you have money in a Roth IRA – Roth IRAs are treated differently than traditional IRAs. Savers can withdraw Roth contributions at any time without penalty. Roth accounts only charge a penalty if earnings are withdrawn before age 59.5. Moving money out of a Roth account makes sense for borrowers who have high-interest student loans. If your student debt is charging 13%, but you only expect to earn 7-10% on your Roth account, moving the money is a logical choice.

The Big Concern with 401(k) and IRA Withdrawals

The problem with raiding your retirement accounts is that you might be trading a difficult problem in the present for an extremely difficult problem in the future.

Imagine for a second that you decided to skip student loan payments for the next three months. In the short term, the next three months would be much easier. However, in the long run, your loan balance will be larger, you will have late fees, and your overall finances will worsen. Pulling money out of a retirement account early is similarly short-sided.

Dealing with student loans is brutal at times, but an underfunded retirement may be an even more significant challenge. Later in life, if you no longer can work and you can’t pay your bills, things will be tough.