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Should I Empty My Retirement Accounts to Pay Off My Student Loans?

Hoca

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The temptation for student loan borrowers to dip into their retirement funds for loan repayment is understandable.

The idea of using 401(k) or IRA savings to reduce immediate student debt burdens can be appealing, considering retirement seems distant while student loans demand immediate attention.

However, this strategy often leads to more financial woes than relief. While there are rare instances where such a move could be beneficial, most borrowers find an alternative approach to be preferable.

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:

  • Income Taxes on Withdrawals: Withdrawing from a 401(k) or traditional IRA incurs income taxes, as these funds are tax-deferred.
  • Early Withdrawal Penalties: If you’re under 59.5 years old, early withdrawals typically trigger a 10% penalty.
  • Reduced Retirement Savings: Using these funds for student loans decreases your retirement savings, potentially leading to financial challenges later in life.

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.

Educational expenses are also included, but this exemption doesn’t extend to student loan payments. Therefore, using retirement funds for a child or grandchild’s education is penalty-free, but the same rule doesn’t apply to paying off your own student loans.

It’s important to note that even in cases where penalty-free withdrawal is possible, it might not always be the wisest financial move if there are better alternatives.

Alternative Options


Rather than tapping into retirement funds, consider these alternatives:

Refinance 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 around 5%. 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: A 401(k) loan, where you borrow from your fund and repay it, could be an option, avoiding taxes and penalties. However, failure to repay means taxes and a 10% penalty.

Reduce Retirement Contributions: Lower your contributions to your retirement fund to free up funds for paying off high-interest student loans, especially if you’re not benefiting from employer matching.

These strategies provide different approaches to managing student debt without compromising retirement savings.

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


Raiding your retirement accounts may provide temporary relief from present difficulties but can lead to severe future challenges.

Consider this scenario: you decide to forgo student loan payments for the next three months. In the short term, it provides some relief. However, in the long run, your loan balance grows, accompanied by late fees, ultimately worsening your overall financial situation. Similarly, prematurely tapping into your retirement account is a short-sighted move.

Managing student loans can be demanding, but facing an underfunded retirement later in life presents even greater challenges. When you can no longer work and struggle to meet your financial obligations, the difficulties multiply.

The post Should I Empty My Retirement Accounts to Pay Off My Student Loans? appeared first on The Student Loan Sherpa.
 
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