Should I Use My 401(k) To Pay Off Student Loans? Pros and Cons

Using your 401(k) to pay off student loans might seem like an easy way to eliminate debt, especially if it's holding you back from reaching other financial goals. In fact, 71% of borrowers have delayed major milestones, like buying a home, because of educational debt, according to a report by Gallup and Lumina Foundation.

While paying off your loans sooner could help you move forward, using money from your 401(k) comes with significant drawbacks, including taxes and penalties. Here's what you need to know before deciding whether to use your retirement savings to pay off student loans.

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Can I use my 401(k) to pay off student loans?

You can use a 401(k) to pay off student loans, but if you're under the age of 59 ½, it comes with financial penalties. There are two primary ways you can access 401(k) funds: requesting an early withdrawal or taking out a loan.

• Early withdrawal: If you take money out of your 401(k) before age 59 ½, you'll face income taxes and a 10% early withdrawal penalty. Plus, the funds are permanently removed from your retirement savings, which can hurt your long-term financial health.
• 401(k) loan: This option lets you borrow against your vested funds without triggering taxes or penalties. However, you must repay the loan within the required time frame. Otherwise, any unpaid amount will be treated as an early withdrawal, subject to income taxes and a 10% penalty if you're under 59 ½.

401(k) loan vs. early withdrawal: Which is better?

If you take money out of your 401(k) before the age of 59 ½, it's considered an early withdrawal. Early withdrawals come with a 10% penalty, plus you'll pay income taxes on the amount withdrawn. For example, if you withdraw $40,000, you could lose thousands to taxes and penalties before even touching your student loan balance.

If you take out a 401(k) loan, you'll avoid the 10% penalty, so it may be a better option than an early withdrawal. Depending on your plan, you may be able to withdraw as much as 50% of your vested account balance or up to $50,000, whichever is less. However, every employer's plan has its own rules, so check with your plan administrator to see what's allowed.

You'll typically have five years to repay the loan with interest, and if you leave your job before the loan is repaid, the balance is due immediately. If you can't repay the loan, it'll be treated as an early withdrawal and will trigger taxes and penalties.

Pros and cons of using a 401(k) for student loans

Here's a look at the biggest pros and cons of cashing out your 401(k) to pay off student debt.

Pros

• Eliminate your debt faster: Withdrawing or borrowing money from your 401(k) can help you pay off your debt faster and reduce the amount you spend on interest.
• Improve your finances: Paying off your student loans will eliminate your monthly loan payments, freeing up your budget to focus on other financial goals.
• No credit check: A 401(k) loan doesn't require a credit check or lender approval, and it won't negatively impact your credit score if you miss a payment.

Cons

• Taxes and penalties: If you're under age 59 ½, early withdrawals come with hefty taxes and penalties. This reduces the actual amount you're able to put toward your student loans.
• Loss of retirement growth: By taking money out of your 401(k), you're losing out on compound interest, which could cost you thousands of dollars in future growth. This could mean a lot less savings by the time you retire.
• Loss of federal borrower protections: If you use your 401(k) to pay off federal student loans, you'll lose access to benefits like income-driven repayment plans and loan forgiveness programs.

Employer 401(k) matching for student loan payments

Some employers now offer a unique benefit that lets you pay off student loans without sacrificing retirement savings. Thanks to the SECURE 2.0 Act of 2022, employers can match your student loan payments and contribute that amount to your 401(k).

Here's how it works: If you make a qualified student loan payment, your employer can treat that payment as if you contributed the same amount to your 401(k). They then match it just like they would a traditional retirement contribution. This allows you to reduce your student loan debt while still growing your retirement savings.

This new option starts in 2025 and could be a game changer for borrowers who want to pay off student loans faster without missing out on valuable retirement benefits. Check with your employer to see if they offer this benefit.

Alternatives to using a 401(k) for student loans

Tapping into your 401(k) to pay off student loans can be costly, with penalties, taxes, and lost retirement growth. Before making that decision, consider these options:

Employer repayment assistance programs

Some employers offer student loan repayment assistance as part of their benefits package. IRS guidelines state employers can contribute as much as $5,250 per year tax-free toward your student loan payments. This money can go directly toward paying down your principal and interest, helping you pay off your loans faster without sacrificing retirement savings.

If your employer offers this benefit, it's worth taking advantage of it before dipping into your 401(k). Check with your HR department to see if this option is available to you.

Refinancing

If you have high-interest student loans, refinancing could help you secure a lower interest rate and lower your monthly payments. Refinancing is generally best for borrowers with strong credit and a stable income. However, be careful about refinancing federal loans since you'll lose valuable borrower protections like income-driven repayment plans and access to loan forgiveness programs.

Debt snowball or avalanche method

When paying off student loans, two popular strategies can help you eliminate debt faster: the debt snowball and debt avalanche methods.

“I would suggest making consistent payments to the biggest interest rate loans, then working your way down. This is the avalanche method. The snowball method utilizes the opposite approach, tackling the smallest balances first. Either way, it's about staying consistent in your payments,” says Anthony DeLuca, a certified financial planner (CFP) and senior financial adviser with Delta Advisory Group.

Income-driven repayment plans

If you have federal loans and are struggling to keep up with your payments, you might consider applying for an income-driven repayment plan. Income-driven plans set your monthly payment at a percentage of your discretionary income. This can add more wiggle room in your budget so you can continue to pay down your loans while saving for retirement.

Another advantage is that any remaining balance is forgiven after you've made the required number of payments, which typically ranges from 10 to 25 years, depending on the plan.