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If you’re fresh out of college and have limited cash flow, paying off student loans can feel like an insurmountable task. It’s easy to fall into the trap because you feel the pressure to pay off your student loans as soon as possible.
But while abolishing student loans is a worthy goal, it’s not worth the sacrifice. For example, if you’re considering using a 401(k) to pay off student loans, you might want to reconsider.
This article explains the various 401(k) taxes and penalties and offers some alternative ways to get rid of student loans.
Taxes and fines for using a 401k to pay off student loans
a A 401(k) is a retirement accountIt is intended to be provided for retirement funding rather than student loan repayment. To help people use their 401(k) properly, there are penalties for early withdrawal. For example, withdrawing funds before you turn 59.5 will result in a 10% penalty. Withdrawing $50,000 will result in an early withdrawal penalty of $5,000.
In addition, you will have to pay income tax on withdrawals. If he withdraws $50,000 from your account, he will add $50,000 to your taxable income. Because this is “additional” income, 401(k) withdrawals are taxed at the highest marginal rate.
For example, a single person earning $125,000 a year has a marginal tax rate of 24%. If she withdraws her $50,000 from her 401(k), she will pay her $5,000 penalty and her 24% tax on the full $50,000 she withdrew. increase. It costs $12,000 in taxes.
In this case, someone who withdraws $50,000 would only have $33,000 left to apply for student loans. While this may be enough to pay off the average student loan balance for 2021 graduates, it comes with a huge opportunity cost.
Withdrawing funds early incurs significant opportunity costs
Even without taxes and penalties, there is a significant opportunity cost to withdrawing money from a 401(k). Let’s say you start saving $175 a month from age 18. Ultimately, by age 62, he could be $1 million (assuming growth is 8% for him). But by the time he’s 30, the monthly savings he needs to reach $1 million more than triples to $575.
When you take money out of your account to pay off a debt, it’s as if the money wasn’t invested at all. We need to increase the savings rate significantly to get on track. The adage “market time beats market timing” is true.
Of course, paying off your student loans gives you peace of mind. But a growing 401(k) will give you more financial security in retirement when your income potential isn’t so great.
How to avoid fines and taxes
Most people under the age of 59.5 will pay taxes and fines when withdrawing money from their 401(k). Thankfully, there are ways to avoid this penalty.
- Look for employers who offer to match student loan payments with 401(k) contributions. The SECURE Act 2.0 was signed into law at the end of 2022. This allows employers to allow employees to contribute to her 401(k) when paying student loans. If you have a large student loan balance, you may want to choose an employer that offers this perk. You can continue to take out student loans while your employer is saving for retirement.
- Wait five years and pay off the loan with a Roth 401(k) donation. With a Roth 401(k), you can donate your after-tax income and grow tax-free. Since he has already paid taxes on his contributions, there are no penalties or tax consequences for withdrawing the funds early (as long as the funds have been in his account for five years). However, this does not mean that an early withdrawal is a good idea. Withdrawing money from your 401(k) is irreversible. Money that can grow over time is spent on loans.
- Use a 401(k) loan. Many employers use a 401(k) to authorize borrowing. A 401(k) loan is a loan from your future self to your present self. When you borrow using a 401(k), you withdraw money from the market and use that money for other expenses. Over time, you slowly pay off the principal of the loan (plus the interest you still have) and the money is reinvested in the market. A 401(k) loan can certainly help you pay off your student loans, but it also comes with risks. As the market has grown significantly, you can also take out a loan. You’ll miss out on that growth because you’ve used that money to pay off your debt. And if you lose your job, you could be required to pay back your loan or be fined.
Alternative Student Loan Repayment Strategies
Withdrawing money from your 401(k) isn’t the best way to pay off your student loans, but there are a few things you can do to speed it up without sacrificing your future retirement. Some of our favorites are listed below.
- Contribute enough 401(k)s to win a match. Many employers offer 50% to 100% matching on all 401(k) contributions, capped at a certain percentage of your earnings. This is the money you should receive as it is part of the reward. He’ll donate enough to his 401(k) to get the perfect match, but use the rest of his earnings to pay off his debt faster. While primarily focusing on your current financial goals, you’ll be making a small investment in your future self.
- Use your side business to increase your income. If you have a clear financial goal, like paying off your student loans, a side job can help you reach that goal faster. Don’t get used to living on this money by using the money from your side hustle to pay off debt. That way, once you’re out of debt, you won’t have to keep working unless it’s fun.
- Try house hacking to keep your living costs down. If you cut yourself off from the fun things in life, you’ll find it harder to pay off your debts. However, there are some ways in which the reduction effect remains. House hacking, or shoving renters into your home or condo, can be a great way to forgive your mortgage for several years while increasing your debt.
- Create a conscious spending plan. A conscious spending plan, or budget, allows you to put more money into debt and less money on non-essential things. Most people struggle to stick to a strict budget over the long term, but this can be a useful tool to help keep your spending steady during the debt repayment process.
final thoughts
Withdrawing money from your 401(k) to pay off student loans isn’t the right move for anyone, but it’s good to know that you still have options to get rid of this debt. If you’re facing the opportunity cost of a 401(k) withdrawal penalty or lost investment potential, we recommend starting with the alternatives above to help you cope with your student loan debt.