Retirement seems like a faraway possibility… maybe even a dream. Meanwhile, student loans can be the nightmare of the present. Taking money out of a 401(k) account to pay down student debt is a real temptation. Why worry about a financial crisis 30 years in the future when you are living a financial crisis right now?
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 student 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.
Finally, pulling money out of a 401(k) account while you are young can rob yourself of significant funds in the future. Over the course of multiple decades, a 401(k) balance can double several times over due to growth and compounding interest.
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. It isn’t a stretch to say that borrowers with federal student loans, especially those working towards forgiveness, have a major incentive to save extra money for retirement.
Borrowing from 401(k) using a loan
One other option that 401(k) savers might be considering would be a 401(k) loan.
Different retirement accounts have different rules, so this option isn’t available to everyone. However, those that can borrow from their own 401(k) are usually able to borrow at a very preferable interest rate. In many cases this rate can be around 2%. These loans usually have a five-year repayment length.
This option can be really tempting. The loan can be used to pay off student debt, which means the high interest rates of existing student loans can be eliminated. Additionally, the 2% interest is the rate you charge yourself. In the case of a 401(k) loan, you are the bank.
There are two major downsides to going with this approach. Problem one is the fact that if you can repay the 401(k) loan according to the loan terms, it is treated as an account withdrawal. That means taxes have to be paid, including penalties for early withdrawal. Given the high penalty for failure to repay the 401(k) loan, this is something that should only be considered by individuals who are very confident they will be able to repay the loan.
The second issue with the 401(k) loan is the lost growth in the retirement account. Most savers expect 7 to 10% growth each year, but any given year could be much higher, or much lower.
Given the risks associated with a 401(k) loan, many borrowers elect to simply refinance the debt rather than messing with their 401(k) account. Going this route protects retirement assets from taxation, fees, and allows the funds to grow undisturbed. With many lenders offering interest rates just over 2%, the cost of a refinance is comparable to a loan. Additionally, by keeping the loan a student loan instead of a 401(k) loan, borrowers can continue to claim the student loan interest deduction.
Student Loan Emergencies
The one item that can really alter your analysis will be late fees and the costs associated with defaulting on your student 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. A student loan default can cause wage garnishments and trash a credit report.
Borrowers with federal student loans can usually avoid this route due to the many federal repayment plans available. The borrowers with private loans are the ones who might find themselves in a more desperate situation.
Using Retirement Funds to Pay Down Student Loans
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.