If you’ve recently graduated from college and find yourself struggling with limited income, paying off your student loans can seem overwhelming. The pressure to repay them as soon as possible can make you feel trapped and desperate for solutions.
However, it’s important to weigh your options carefully before making any drastic decisions. One such choice that may not be worth it is dipping into your 401(k) to pay off your student loans. In this article, we’ll discuss the taxes and penalties associated with using your 401(k) for this purpose, and suggest alternative methods to effectively tackle your student loan debt.
Taxes And Penalties If You Use Your 401k For Student Loan Repayment
A 401(k) is a type of retirement plan that allows you to save for the future, primarily for your retirement needs. It is critical to use it for its intended purpose, and sanctions are in place to discourage early withdrawals. Let me demonstrate how this works:
If you take funds from your 401(k) before the age of 59.5, you will be penalized 10% of the amount withdrawn. So, if you withdraw $50,000 early, you must pay a $5,000 penalty.
Furthermore, any funds withdrawn from your 401(k) are taxable income. So, in our $50,000 example, that sum would be added to your taxable income. This will be taxed at your highest marginal tax rate because it is deemed additional income.
Consider a single person earning $125,000 and paying a marginal tax rate of 24%. If this person withdraws $50,000 from their 401(k), they must pay a $5,000 penalty plus 24% tax on the whole amount removed, totaling $12,000 in taxes.
As a result, in this case, the person withdrawing $50,000 would have only $33,000 to spend on school loans. While this may be enough to pay off the typical student loan load for a graduate in 2022, there is a large opportunity cost involved with this approach.
Withdrawing Money Early Has A Huge Opportunity Cost
Withdrawing money from your 401(k) can have significant effects in the future, even before taxes and penalties are considered. Let me illustrate with an example: Assume you begin saving $175 each month at the age of 18. Assuming an 8% growth rate, you may have around $1 million in your account by the age of 62. If you withdraw funds from your account to pay off debt, it’s as if you never invested the funds in the first place. You would need to dramatically boost your monthly savings to catch up and attain that $1 million goal by age 62. The required monthly savings would more than triple to $575 by the age of 30.
The saying “time in the market beats timing the market” is correct. You may increase your financial stability for the future by keeping your money invested in a rising 401(k). While repaying student loans gives you piece of mind, a rising 401(k) can provide you with improved financial stability during your retirement years, when your earning capacity may be decreased.
Ways To Avoid Penalties and Taxes
When most persons under the age of 59.5 take money from their 401(k), they must pay taxes and penalties. Fortunately, there are a few options for avoiding this penalty.
- Look for an employer that will match your student loan payments with 401(k) contributions: Employers can now contribute to your 401(k) when you make student loan payments under the new SECURE Act 2.0. If you have a large student loan amount, it’s worth looking into employers who provide this perk. You can continue to pay off your loans while your company saves money for your retirement.
- Consider repaying your loans with Roth 401(k) contributions in five years: A Roth 401(k) allows you to contribute money after-tax, and the growth is tax-free. After contributing for at least five years, you can utilize the money to repay your student debts without penalty or tax consequences. However, early withdrawal from your 401(k) is generally not advised because you will be unable to reinvest the funds. It’s critical to recognize that early withdrawals from your 401(k) forfeit the compounded growth that the money could have attained over time.
- Investigate 401(k) loans: Many workplaces allow you to borrow against your 401(k) assets. This is analogous to borrowing money from your future self to cover current expenses. When you take out a 401(k) loan, you take money from your investment portfolio and utilize it for anything else, such as paying off your student loans. You repay the loan principal (plus interest) over time, and your money is reinvested in the market. While a 401(k) loan can help you pay down your student loans, you should be aware of the hazards. If the market grows significantly while you have a loan, you will miss out because the borrowed money was utilized to pay off debt. Additionally, if you lose your job, you may be required to repay the loan or face penalties.
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Alternative Student Loan Payoff Strategies
Here are a few strategies that can help you pay off your student loans faster without jeopardizing your retirement:
- Contribute enough to your 401(k) to receive the employer match: Several companies will match your 401(k) contribution up to a specified percentage of your income. It is critical to take advantage of this free money by giving enough to receive the full match. This allows you to invest in your future while still devoting the majority of your income to debt repayment.
- Explore side hustles to increase your earnings: Having a side hustle can help you pay off your debt faster. Use the extra money from your side job entirely to pay down your debts. You can put this money towards your debt by not using it for ordinary expenses. When your loans are paid off, you can determine whether or not to continue with your side hustle.
- Consider house hacking to reduce living expenses: House hacking is an excellent strategy to reduce your living expenses. Renting out a section of your home or property to create rental revenue is what this entails. This allows you to potentially eliminate or drastically cut your mortgage payments, allowing you to devote more funds to debt repayment.
- Create a conscious spending plan (budget): Developing a conscious spending plan or budget can help you prioritize your finances and allocate more money towards debt repayment. While it may be challenging to stick to a strict budget long-term, it can serve as a helpful tool during your debt payoff journey, ensuring that you’re spending money on what truly matters.
Should I cash out my 401k to pay off debt?
Taking money from your 401(k) “can make sense to use funds to pay off high-interest debt, like credit cards,” Tayne writes. On the negative side, your retirement savings amount will decrease. You may experience financial difficulties later if you do not have a plan to remain out of debt and create long-term savings.
What 401k means?
A 401(k) plan is a type of qualified profit-sharing plan that allows employees to contribute a part of their earnings to individual accounts. Except for authorized Roth deferrals, elective salary deferrals are not taxable to the employee. Employers can make contributions to their employees’ accounts.
How does a 401k work?
A 401(k) allows an employee to designate a portion of their salary to be deducted from each paycheck and invested in their account. Participants can deploy their funds among the plan’s investment options, which often include a number of mutual funds.
Can I repay 401k loan in lump sum?
If you have the cash, you can certainly repay your 401(k) loan in a lump payment. A lump sum payment may be your only option if you want to pay off your 401(k) loan sooner. You’ll need to work with your 401(k) administrator to figure out how to pay off your debt in one large sum.
Final Thoughts
Withdrawing funds from your 401(k) to pay off student debts may not be the best decision for everyone, but it’s good to know that you still have options for getting out of debt. If you’re facing 401(k) withdrawal penalties as well as the opportunity cost of lost investment potential, I propose beginning with the above-mentioned methods to pay off your student loans.