My husband and I have been paying off our student loans for over 10 years, and we still owe more than most people ever borrowed. It’s been a completely exhausting ride. Excited doesn’t even begin to describe how we’ll feel when we make that last student loan payment.
As our student loan balances decrease and our 401(k) balances increase, it’s natural to look at our 401(k) savings as a savior. We have a growing pot of money that is ours. Can’t we use that to fill in the hole made by our student loans?
Though it seems like an easy button, is it even possible to borrow from your 401(k) to pay off your student loans? And if so, is it ever smart to use your 401(k) to pay off student loans?
Semantics: Borrowing vs Withdrawing
When most people ask “should I borrow from my 401(k)?” they really mean, “should I take a withdrawal from my 401(k)?” Despite the tendency to use these ideas interchangeably, there is a difference.
Borrowing from your 401(k) indicates you’ll pay yourself back. Withdrawing from your 401(k) means you’re taking the money, but don’t intend to replace it.
Most employers will allow a personal loan from your 401(k). You can borrow the lesser of $50,000 or half of your vested equity. That means if you have a vested equity of $60,000, you can only borrow $30,000.
When you borrow from your 401(k), you generally have up to 5 years to pay it back. However, if you cease to be employed at your job for any reason (whether you quit, get fired, or are laid off), the balance of the loan will become due immediately. You won’t be allowed to continue contributing to your 401(k) until the loan is paid off, which also means you’ll forgo employer matching.
On the other hand, when you take a withdrawal from your 401(k), you’re taking the money and running. You never have to pay yourself back. However, the IRS doesn’t want you waking up one day and just taking all your 401(k) money until it’s time to retire.
If you’re younger than 59.5 years, you can only withdraw money without penalty if you’re facing a significant financial hardship. These hardships include preventing foreclosure/eviction, paying for a funeral, or repairing to your primary residence.
If you do take a withdrawal and don’t have a financial hardship, you’ll have to pay taxes on the money, plus an early withdrawal penalty (generally 10%). That means a withdrawal of $50,000 might only be $30,000 in your pocket. Note that the disbursement might also change your tax bracket for the year!
The Short Term Math
Most people will decide against a 401(k) withdrawal to pay off student loans unless they qualify for a financial hardship because of the hefty penalties faced. That leaves them with the choice of taking out a loan to pay off their other loans. Even then, the math doesn’t always support that option.
Since you have to pay the 401(k) loan back in 5 years, this option is likely not viable if you have more than 5 years left on your student loan payments – unless there’s some reason you think you can pay extra each month. For example: Becky has 6 years left on her student loans. Her monthly student loan payments are $231 and she has just over $14,000 left on her student loans. Because the 401(k) loan is interest free, Becky can probably pay off her 401(k) loan within 5 years if she’s able to contribute a few additional dollars a month ($231 x 12 months x 5 years = $13,860).
In this example, it’s a close call, but Becky can probably handle the 401(k) loan. Is that her only option? No.
Instead of taking a loan, Becky could cease to make 401(k) contributions and apply the money toward her student loans. Perhaps Becky contributes around $250 a month to her 401(k), so at first it seems like an easy substitute. However, 401(k) contributions are pre-tax, so if Becky stopped contributing to her 401(k), she wouldn’t see a $250 bump in her monthly pay.
Finally, Becky could take a withdrawal from her 401(k). She could continue to contribute to her 401(k) as she always has, but her starting balance will be less, which will have some affect on the long-term math.
Decreased Retirement Savings
If you decide to take out a 401(k) loan, you won’t be able to contribute to your 401(k) until the loan has been paid back. The math for the implications gets pretty intense, so let’s just look at the impact made by the loss of contributions for 5 years.
Let’s consider Lisa, who currently contributes $300 a month to her 401(k), which currently has a balance of $75,000. Let’s assume she averages a modest increase of 6% per year off her investments. Lisa has to decide if taking a $20,000 loan from her 401(k) to pay off student loans is worth it.
If Lisa continues to invest just as she has been doing, while also receiving an employer match for her $300, she will have over $140,000 in her 401(k) by the end of the 5 years.
However, if she cuts her balance to $55,000 and pays herself back over 5 years, she will end up with less than $100,000 in her account. In this scenario, the $20,000 loan ended up costing Lisa over $40,000!
If Lisa opted for a 401(k) withdrawal, she would have had to withdraw around $32,000 in order to pay taxes and the IRS penalty and still have $20,000 to pay off her loans. Her 401(k) balance is now $43,000. However, she’s able to continue contributing to her 401(k) and receive employer matching.
Now that her student loans are paid off, she’s also able to increase her 401(k) contribution to $450 a month, though she’s maxed out her employer contribution. After 5 years, Lisa will have over $110,000 in her 401(k) which means that the withdrawal makes more financial sense than the loan.
However, the math depends upon Lisa contributing more after paying off her student loans. If Lisa wanted to pay off her student loans in order to quit her job or afford medical treatment, then this math doesn’t hold up.
Pay Up Now
Perhaps you’ve read through the rest of the information and you still think the 401(k) loan seems like the right call. How confident are you that you’ll remain employed with your present employer for the next 5 years?
First of all it’s hard to know how your company will fare 5 years from now. Plenty of companies were thought to be rock-solid in 2006, only to close their doors after the 2008 bust.
Second, even if you’re doing quite well in the company, if management changes, you might find yourself left out in the cold.
Finally, you might be happy enough in your present position, but will you feel the same in 5 years? If you get passed over for a promotion, you can’t storm out the door to greener pastures unless you’re able to pay back your 401(k) loan in full.
If you leave your position for any reason, the loan must be paid in full, usually within 2 months, or the remaining balance will be treated like a withdrawal. That means you’ll pay taxes on it, possibly increasing your tax bracket for the year. You’ll also owe the 10% penalty.
Credit Building Opportunity
Despite the fact many people are anxious to wave goodbye to their student loan debt, carrying a student loan balance isn’t all bad news. If you’re able to manage the payments, then your student loans are helping you build a good credit history.
Student loans are reported to credit bureaus as installment loans. Installment loans aren’t heavily weighted in a credit score, but they are a contributing factor. On the other hand, if your student loans are the only line of credit you have (no mortgage, car loans, or credit cards), you credit score may actually drop a few points when you pay off the loans.
Every situation is unique. Some circumstances might warrant making a “bad” financial call in order to pursue something that’s the best choice for you.
If you have an exceptional case, the key is to educate yourself. Understand the financial impacts of your decision, both short term and long term. Ensure you’re aware of any risk you’re accepting. And it’s never a bad idea to seek advice from professionals, wise friends, family members before proceeding.
What about you? Have you ever thought about using your 401(k) to pay off your student loans? How does the math look for your situation?