Repayment of student loans can be a long, arduous process. If you are fortunate enough to land a high-paying job right out of college, it may not be the worst thing. However, you must never ignore the possibility that your income might not be sufficient for repayments. So, what can you do in such a case? You might feel desperate and even angry. Well, this is where your 401(K) plan can step in. You can cash out your savings and repay the loan (once you have enough saved in there, of course). By doing this, you will soon be free of any monthly repayment obligations related to your student debt. These days, most graduates are getting more and more scared of carrying on their student debt for prolonged periods. While it might be quite tempting to reach into your 401(k) to pay off the debt, there are certain repercussions you must consider.
Average student debt
According to statistics provided by U.S. News and World Report, the average American graduates from college with a student debt of around $28,000. With the interest rate at 6%, these graduates will be paying about $312 as their average monthly repayment. For a recent graduate, $300 per month is quite steep. So, not having any loans or debts to worry about can be quite refreshing. In fact, in a report that was published by the American Student Assistance, it was said that about 40% of individuals with student debt prefer to put off starting a family until they are debt free and about 25% admitted that buying necessities was becoming a challenge with the repayments that they have to make.
Why people dip into 401(k)?
The main reason people dip into their 401(K) savings is to repay student debt for lifestyle freedom. Also, by repaying the debt as soon as possible, you avoid having to pay higher rates of interest later. Well, the principal sum borrowed will certainly stay the same, but the amount of interest payable will keep increasing, and this increases the total sum payable.
When it comes to using your 401(K) for repayment of student debt, you have two options. You can either withdraw or borrow from it.
Withdrawing from 401(k)
Making a 401(k) withdrawal before the age of 59 ½ years entails a 10% penalty. Apart from this, the money you withdraw will be deemed a part of your taxable income. This applies to any funds you may withdraw from the account regardless of whether it was a contribution by your employer or yourself. You might wonder if you can withdraw from the IRA instead of the 401(K). Well, the same penalties will be applicable.
Borrowing from 401(k)
You don’t necessarily have to withdraw from your 401(K) to repay a debt; you can also borrow from it. The IRS sets the limit on these loans to $50,000 or half of the balance in the account (whichever is smaller), and the interest rates applicable are quite reasonable when compared to the rates prevalent in the market. Also, this is quite helpful for those who have a low credit score and cannot borrow funds from other sources to refinance debt.
Whenever you borrow from your 401(K), you are repaying the amount to yourself with interest. Your employer will not retain interest. The principle is that you essentially ‘borrow’ from yourself and ‘pay’ yourself the interest directly into your 401(K) again.
Using your 401(k) to repay student debt is quite controversial
Using your 401(k) to repay student debt either through an early withdrawal or a loan is quite controversial. We feel that using 401(k) for debt repayment isn’t a good idea (refer to Mistake #7) especially for low-interest rate debts like public student loans. Sacrificing your future to pay for a past debt is a bad idea. If you do this, you will be withdrawing funds that will earn you 7-8% non-taxable interest to pay off a less than 5% interest debt and that interest is tax-deductible.
Any contributions and withdrawals made during your early years of savings will have a huge impact on your finances at the time of retirement. The later you start to save, the lesser will be the amount you accumulate by the time you retire. Someone who starts to save in their early 40s cannot possibly catch up with someone who started saving in their 20s. Also, before you decide to borrow from your 401(k), ensure that you have job security.
So, is it a good idea to sacrifice funds saved for your retirement to repay student debt? The decision is entirely up to you, and it is a personal one. However, before you decide to reach into your retirement funds, it is always a good idea to consult a financial advisor for some suggestions. After all, you must try to secure your future while trying to become debt-free as soon as possible.
Until next time!
Author; Sunil Gangwani