Early Withdrawal Penalty Exceptions
There are several circumstances where an IRA or 401 early withdrawal penalty can be avoided. These exceptions include buying a first home, medical expenses, and Covid-19.
Notably, educational expenses are an eligible reason for an early withdrawal from an IRA. Unfortuantely, the educational expenses category does not include student loans. This means you can use your retirement funds to pay for your child or grandchilds education, but if you still have student loans, you face the early withdrawal penalty.
Even if your circumstances justify a penalty-free withdrawal, it still might be a mistake to pull money out of the retirement account. A penalty-free withdrawal is a mistake when better alternatives are available.
Paying Off Loans Vs Saving For Retirement
Paying off student debt is an important part of achieving financial stability. But retirement can last 30 years or more, depending on when you stop working and how long you live.
To cover both living and medical expenses , you will need to replace at least 80% of your income during retirement. Social Security likely will not cover your full living expenses in 2021, the average monthly Social Security payment is $1,555.
Starting to save for retirement early is as important as paying off student loans because of the impact of compound interest. For example, if you save $50 per month over 20 years, you will have to set aside a total of $600 per year, or $12,000 total. But with compound interest of 6%, that will be worth over $23,000nearly double the amount that you contributed.
Before you begin making extra student loan payments, use a retirement calculator to see whether your savings are on track. Once you are regularly saving for retirement, you can look into making additional student loan payments.
The Interest Rate On A 401 Loan Is Lower
Interest rates on federal student loans are generally low, and may also be lower than the interest rate on a 401 loan.
But if you have a private student loan from a bank, you may be paying a higher interest rate.
If your student loan payments are too expensive and pose a financial burden, using your 401 to pay off this loan makes sense if the interest rate on your 401 loan is much lower.
Your 401 loan payments may also be lower than your current student loan payment, providing a little breathing room in your budget.
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Can Retirement Funds From A 401 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 doesnt mean you should.
There are three major issues with taking money out of a retirement account to knock out student debt:
- Removing money from a 401 or traditional IRA means paying income taxes. Contributions and growth of these accounts are not taxed, but income taxes must be paid when the money comes out.
- Early withdrawals usually trigger a penalty. In addition to income taxes, there is a 10% penalty if you are under 59.5 years of age.
- A smaller balance means less money for retirement. Turning your student loan problems into a retirement problem is often a lousy trade. Help for seniors who go broke during retirement is limited.
Why A 401 Loan Is Typically A Better Option To Pay Off Your Student Loans Than An Early Withdrawal
If after weighing the pros and cons, you still want to use your 401 to pay off your student loans, then Gillette suggests considering taking out a 401 loan instead of a withdrawal.
Because 401 loans offer several advantages that good old withdrawals dont offer.
- Not having to pay a 10% tax penalty. Since youll be borrowing money, not withdrawing it, you wont be penalized by the IRS.
- Youll save money on taxes. The borrowed amount wont count as part of your ordinary income for that year, so you wont have to pay any taxes on it.
- Lower impact on your long-term retirement plan. Like Gillette mentioned, since youll be paying yourself back with interest borrowing money from your 401 wont set you back, in terms of future earnings, as much as a plain withdrawal.
But even if a 401 loan is a better option than withdrawing the funds, there are certain considerations you need to keep in mind before taking the plunge.
These are some of the most important ones:
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Youll Miss Out On Market Gains
Borrowing from your 401 will decrease the amount of money in your retirement account.
Even if you borrow funds for a good purpose, less money in your account means youll miss out on market gains and compounded earningswhich you would have received if you left the funds in the account.
For example, if you have $30,000 in a 401 and you borrow $10,000, youll only earn gains on the $20,000 until you repay the loan.
Slower gains can also occur if you temporarily lower your 401 contributions while paying back your loan.
Putting less money in your retirement account also reduces how much your employer contributes, if the company you work for offers a match program.
How They Affect You Negatively
If youre itching to get rid of your student loan debt and you have plenty of money in your 401, you may see no harm in borrowing from this account.
Maybe youre still young and feel theres plenty of time to recoup the money.
Because youre paying back the account, you could also argue that a loan is far better than a 401 withdrawal. This is when you take money from your account without repaying it.
But while the above points are true, a 401 loan can have negative ramifications.
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When To Pay Off Student Loans
Paying off student loans first can take some time, but for many borrowers, it can relieve a lot of stress and free up more cash for other goals, including investing. It can also make your life feel a little less complicated. You should consider paying off your student loans if you have high interest rates, you have an unpredictable cash flow or youre looking to remove debt from your finances.
- Youll save money in interest.
- Youll become debt-free sooner.
- Your debt-to-income ratio will improve, making it easier to qualify for a mortgage.
- It can take several years to pay off your student loans, even with extra payments.
- Its unnecessary if youre working toward loan forgiveness or repayment assistance.
- You wont be able to maximize the student loan interest deduction.
- People whose top priority is to be debt-free.
- Borrowers with high-interest student loans .
- People hoping to purchase a home but who cant because of a high DTI.
Can You Pay Off Student Loans With Your 401
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If youre one of the 44 million Americans who currently hold a portion of the countrys $1.5 trillion student debt , chances are youve got student loans on the brain. The average student graduates with just over $37,000 in student loan debt.
Paying off that much debt is an impressive feat which takes discipline and commitment. If youre currently living under the heavy weight of your student loans, you may have considered using your 401 for student loans. But should you really cash out your 401 for student loans?
It probably goes without saying that figuring out how youre going to pay off your student loans is overwhelmingand there isnt one definitive solution. And while its certainly tempting to just take the cash from your 401 and pay off a high-interest loan, there are some serious drawbacks to consider before running with that plan.
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Benefits Of Using Your 401 To Pay For Student Loans
If you choose to pay off your student loans with money from your 401 plan, youll have immediate access to the money. You can then make a one-time payment and be rid of your student loans forever. This alone can be a huge mental and financial burden. Plus, you wont accrue interest on your student debt and you wont have to make monthly student loan payments. For example, you can immediately reduce your current monthly expenses by forgiving your student loans.
You Have Bad Credit And Cannot Qualify For Refinancing
Student loan consolidation or refinancing can help you get a lower interest rate and a lower monthly payment.
But qualifying for refinancing will likely require a credit check, and you may not qualify with a low credit score.
If you cant qualify but desperately need a lower payment, using a 401 loan to off your student debt might be the solution.
Chances are, youll get a lower rate on your 401 loan.
And because a 401 loan doesnt involve a credit check, you dont have to worry about bad credit disqualifying you.
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Rules For Withdrawing From Your 401
Can you use your 401k to pay off student loans? The short answer is yes, but since the funds in your 401 are meant for retirement, there are many rules for withdrawing funds prior to that time. It is important to fully understand the guidelines for withdrawing before using money from your 401 to pay off student loans. Here are the rules to know:
- You will pay a 10% penalty tax for withdrawing money from your 401 if you are under 59 ½ years old.
- You will need to pay federal income taxes on the withdrawn amount.
- Some states may require you to pay state income taxes on the amount you withdrew.
- An exception to the withdrawal penalty is an IRS guideline known as the rule of 55. If you are age 55 or later and leave your job for any reason, whether your own doing or by your company, you can withdraw funds from your 401 penalty free. You will still owe income taxes though.
Alternatives To Borrowing From Retirement
Dipping into your 401 likely will lead to more troubles than its worth. There are other ways to get by while keeping your retirement funds intact. Learn more about prioritizing retirement vs paying off debt.
Here are some methods of dealing with a financial emergency:
- Home equity loan This is a good option for homeowners. It comes with a fixed interest rate that never changes. Right now, the average home equity loan rate is 7.74%.
- A personal loan Even if the interest is higher than youd like, its often better than interfering with the appreciation of your 401. If you have a credit score above 720, you may be able to find interest rates around 10%.
- Nonprofit credit counseling Maybe you dont feel comfortable putting your home up for collateral,or your credit is too low for a decent interest rate on a loan. Consider working with a nonprofit credit counseling agency. A credit counselor will take a look at your budget, walk you through your spending habits and help you establish a more manageable financial lifestyle.
A 401 is first and foremost a retirement account, not just a second savings or vacation fund. The tulips have been blooming in Holland for 400 years. Theyll be around down the line when youre financially ready and able.
In the meantime, keep making contributions to your 401. Let it sit. Watch it grow. Youll thank yourself later.
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Taking Funds From Your 401
Anyone is allowed to take funds from their 401. However, doing so before the age of 59½ will result in a penalty of 10% of your withdrawal on your tax return. On top of that, the withdrawal will be taxed as income. So, no matter what amount you withdraw, youll end up losing money that could have been saved.
Additionally, withdrawing from your 401 before 59½ will cause you to lose any compound interest that would have been earned on those funds.
Also see: All about paying off student loans early
Take A Hardship Withdrawal
A less appealing option to pay for higher education expenses with funds from your 401 is a hardship withdrawal. If you already attended college and used student loans to pay your tuition, a hardship withdrawal cannotbe used to repay your loans. However, if you plan on attending school in the next year and cannot otherwise afford to pay your tuition, you may be able to withdraw money from your 401 to pay your tuition, room and board, and other related expenses using this tool.
Unlike a loan, funds taken as part of a hardship withdrawal cannot be paid back to your 401 account.
You may also be able to take a hardship withdrawal to pay the tuition and education expenses of a child, spouse, or dependent who is planning on attending school within 12 months. Either way, if you are younger than 59½, or 55 under certain circumstances as described above, you will still pay a 10% penalty on the amount withdrawn and also be subject to income tax.
To qualify for a hardship withdrawal to fund your education, you must meet certain criteria. Firstly, you must be able to prove your need is immediate and heavy. A student loan is not an immediate expense because it already provides for repayment over time. However, tuition for the upcoming school year does qualify as immediate.
For your need to be considered heavy, the expense must be important and large enough that it could not easily be met by working a few more hours or cutting out your weekly movie night.
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Should You Use Your 401 To Pay Off Student Loans
Modified date: Jan. 26, 2022
If youve been working for a while and contributing to your companys 401, you might feel tempted to use some of that cash to wipe out your student loans and I dont blame you.
Saving thousands on interest and allocating those funds toward things, like buying a house or beefing up your savings, sounds like a good plan, especially if youre light-years away from retirement.
But even if it seems like a good idea, dipping into your 401 before youre supposed to, shouldnt be taken lightly. Not only youll be cutting yourself short from future earnings, but could also face a hefty tax bill.
Should I Use My 401 To Pay Off Student Loans
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If You Want To Pay Off Your Student Loans Fast
You may not have trouble paying your student loans but want to pay them off quickly for other reasons. Maybe you want to decrease your debt-to-income ratio or are stressed by having the debt hang over your head.
In these cases, consider other methods to pay down your student loans fast, before depleting your 401 and potentially hampering your retirement. Common methods include student loan refinancing and tactics such as making payments biweekly.
About the author:Cecilia Clark is a student loans writer with NerdWallet, where she helps readers navigate the landscape around college finances.Read more
Why He Doesn’t Recommend You Do An Early Withdrawal
Looking back, Nitzsche says that liquidating his 401 to pay off credit card debtis something he wouldn’t do again.
“It is so detrimental to your long-term financial health and your retirement,” he says.
Many experts agree that tapping into your retirement savings early can have long-term effects. It can put you at risk later on in life when you are older, not working and would otherwise need to rely on those funds.
There are also short-term effects from making an early withdrawal from your 401 as well: It doesn’t come free. Doing so has costly consequences, including both a penalty fee and taxes. For borrowers 59½ years old and younger, there is generally an early withdrawal penalty of 10%, plus taxes, which can be anywhere from 20% to 25% depending on your income and tax bracket.
If you are someone who is cash-strapped during this time of uncertainty, tapping into your retirement savings is an option of last resort. “That really should not have been touched and not something we would usually advise somebody to do,” Nitzsche says.
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Q: I’m 57 Years Old And My Oldest Child Is About To Start College Can I Tap Into My 401 To Help Pay For Tuition Without Paying A Penalty
While an IRA allows the owner to withdraw money penalty-free at any time to help pay for college, 401s and similar retirement plans don’t have this feature. However, this doesn’t necessarily mean that you can’t use yours.
Specifically, there are two ways you might be able to use your 401 funds to pay for college without penalty. First, unlike an IRA, you can usually borrow money from your 401. Most plans allow for loans of up to $50,000, and the interest rate you’ll pay is likely to be far lower than you’ll get from a parent student loan — plus you’ll be paying yourself the money and building your retirement fund back up.
Alternatively, you said that you’re 57. That still puts you below the standard withdrawal age of 59 1/2, but there’s a special provision that allows you to withdraw from your account penalty-free after 55 if you are no longer working for the sponsoring employer. In other words, if you have an old 401 from a previous employer, you can use it without a penalty at your age. It’s important to realize that if you withdraw money under this rule, it won’t be penalized but it will be considered taxable income.
So while you can’t withdraw from your account penalty-free specifically for college purposes, there are still ways you can potentially use your 401 savings to help cover the costs.