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 Does Cashing Out Your 401 Work
When you cash out your 401, not borrow it, you will have to pay taxes on the money that you withdraw, as well as a 10% penalty if you are under the age of 59 ½. The reason for the tax and penalty is that when you take the money out of your 401, you are not just taking out the contributions that you have made, but also the earnings on those contributions. This is different from taking a loan from your 401 because, with a loan, you are only borrowing the contributions, not the earnings.
When considering cashing out your 401, keep in mind that you are losing the opportunity to continue receiving tax-deferred earnings on the money you withdraw. Most importantly, if you cash out your 401, you will not have any money saved for retirement.
Alternatives To Help Control Your Student Loan Debt
If youre struggling with student loan payments, dont feel paralyzed. Borrowing money from your 401 isnt the only option available to you. There are alternatives that can help you get your student loan debt under control while keeping your retirement savings intact. One option that could provide some relief to borrowers who are strapped for cash is student loan refinancing.
When you refinance your student loans youll take out a brand new loan from a private lender, who will review your credit history and other financial factors to determine how much they will lend to you and at what rate.
With a solid financial picture and credit history, you can stand to lower your interest ratemeaning you could reduce the amount of money you spend in interest over the life of the loan .
You could also lower your monthly payments by extending the length of the loan term, which would ultimately mean you spend more money in interest over the life of the loan, but could help free up some cash flow more immediately.
However, its important to remember that refinancing with a private lender means youll lose access to federal loan benefits like income-driven repayment plans, forbearance, and deferment.
Take control of your student loan debt by refinancing with SoFi. Find out what your new interest rate could be in just a few minutes.
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If You Have Federal Student Loans
Apply for an income-driven repayment plan
One of the perks of having a federal loan over a private one is that you get access to multiple repayment options that are easier on your wallet than the standard repayment plan.
When you apply for anincome-driven repayment plan, your monthly payment is based on your family size and how much you earn, and generally ranges between 10% and 20% of your discretionary income.
You can apply for an income-driven repayment plan by logging into your account on StudentAid.gov.
Read more: 5 Things You Must Know Before Doing An Income-Driven Student Loan Repayment Plan
Consider loan consolidation
The only drawback is that, by extending your repayment term, you may end up paying more on interest long-term, so thats something to consider before applying for this type of loan.
This has been kind of a mess in the past, but the federal government has been making changes to thePSLF program to make it easier for borrowers to get their debt forgiven.
If youre currently employed by a federal, state, local, or tribal government agency, or at a non-profit organization, you may be eligible to get your remaining federal student loan balance forgiven after making 120 consecutive payments.
Although youll pay taxes on the forgiven amount, this will just be a one-time thing. To explore this option, contact your student loan servicer to see if you meet the eligibility requirements before you apply.
Put your loans in deferment or forbearance
How Much Would Using Your Ira To Pay Student Loans Cost You
Not only could borrowing from your retirement savings early cost you a hefty amount in taxes and fees, but it could also cost you in earnings you might otherwise get if you left the money in your account.
Lets say your normal income tax rate is 24%. With the 10% penalty you could get on an early withdrawal, youll essentially be paying 34% of your distribution. If you withdrew $10,000 from your IRA early to pay off your student loans, youll owe $3,400 in taxes and fees.
Whats more, your retirement plan custodian might hold back 20% automatically to cover taxes. While you might get some of this amount back during tax season, youll likely have to plan for it to be held back.
So instead of getting the full $10,000, you might only get $8,000 upfront. And if you make an especially large withdrawal, you could get bumped into a higher tax bracket, meaning youll pay even more taxes than normal.
Now lets say that you kept that $10,000 in your retirement savings account. If you got a 7% annual rate of return, youd have about $19,672 in your account after 10 years. After 20 years, youd have $38,697 in your account.
This is assuming that you dont make additional contributions to your IRA or 401. If you keep saving money in your retirement account, youll make even more over the years due to compound interest. But if you take that money out of your IRA to pay off student loans, youll miss out on those earnings.
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Significant Reform To Retire Retirement Savings
Keller, who opposes student loan forgiveness, says the proposed SECURE 2.0 reforms are a sustainable model for how to help students that has a good chance of passage.
I look forward to doing everything we can to get this across the finish line in 2022, he said.
Other provisions in the legislation, called the Securing a Strong Retirement Act of 2021, concern raising the required minimum distribution age when people must start taking money out of their private retirement plans as well as measures to push employers to automatically enroll new employees in retirement plans.
In late 2019, Congress passed “SECURE 1.0,” the first major retirement legislation in years it included 401 provisions to help part-time workers save and improved access to annuities among other changes.
In an interview with Yahoo Finance, House Ways and Means Ranking member Kevin Brady listed further retirement reforms as one of his top priorities for 2022. Noting that SECURE 2.0 has bipartisan support and would be another significant reform to retirement savings, he expressed hope that it could get done in the coming 12 months.
For now, student debtors have a reprieve from paying off their federal student loans. The U.S. government paused federal student loan repayments through Jan. 31 in response to the pandemic, and President Joe Biden recently announced an extension through May 1.
Ben Werschkul is a writer and producer for Yahoo Finance in Washington, DC.
Consequences Of Early Withdrawals
Beyond the taxes and penalties you might trigger by making an early withdrawal from your 401, you might want to consider the effects such a withdrawal will have on your retirement funds. You will lose the benefit of deferred taxation on the withdrawn amount, and you cant replenish the withdrawn money. That is, the same annual limit on your 401 contributions applies whether or not youve taken an early withdrawal. You, therefore, run the risk of shortchanging your retirement by making early withdrawals.
You can opt to repay student loans with a 401 loan instead of an early withdrawal, but keep in mind that the interest on student loans is tax deductible. Youll have to consider whether it makes sense to give up the student loan interest tax-deduction in favor of non-deductible 401 loan interest that you must pay to your account.
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Using A Traditional Ira To Pay Off Student Loans
An independent retirement account is a tax-advantaged account designed to help you save for retirement. You contribute pre-tax dollars and can withdraw your money without penalty once youve reached the age of 59½. But if you withdraw that money earlier, whether to pay off student loans or something else, youll likely be charged both income tax and early withdrawal penalties.
To be specific, the IRS imposes a 10% penalty on early withdrawals of taxable funds. Note that there are a few exceptions to this rule. For example, you wont be charged this fee if youre unable to earn an income due to a total and permanent disability.
Unless youre exempt, however, youll have to pay this fee in addition to income tax. When you compare the penalties and fees to the interest rate on your student loans, youll probably find that this approach isnt worth the extra costs.
How The Bill Would Help
The Securing a Strong Retirement Act permits retirement plans such as employer-sponsored 401 plans to make matching contributions to workers as if their student-loan payments were retirement-plan contributions. Qualified student-loan payments are broadly defined under the legislation as any indebtedness incurred by the employee solely to pay qualified higher education expenses of the employee.
According to the Association of American Medical Colleges, 73% of medical students graduated with an average of about $200,000 in student-loan debt, meaning that paying down that debt is often the top financial priority for younger physicians. This can be particularly burdensome during residency training, when salaries are considerably lower than those of physicians who have completed their graduate-level training.
The bill has been a priority for the AMA during this legislative session.
The cost of medical school is high and will continue to climb, and that can have ramifications in all different facets of life and career, said Christopher Sherin, the AMA’s assistant director of congressional affairs. This is just one of those opportunities that we thought was advantageous to our membership, particularly on the younger membership side.
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Consider Refinancing Your Student Loans
If you have good credit or can apply with a cosigner who does consider refinancing your student loans for lower rates and new terms. When you refinance, you can combine multiple loans into one to simplify repayment.
Plus, you might get a better interest rate, resulting in lower costs over the life of your loan. Finally, you can choose new terms and with them, an adjusted monthly payment.
Be cautious about refinancing federal student loans, however, as doing so turns them private and thus ineligible for federal repayment plans, forgiveness programs and other protections.
One Recent College Graduate Offers Three Tips To Guide The Decision
When I graduated from college, I was happy to have my degree and a job lined up but, even with those two accomplishments under my belt, there came an immediate sense of responsibility. While I was lucky to receive some financial support during my undergraduate career, I still came out with $33,000 in student debt. Add to that a monthly rent payment, a new car loan, utilities, groceries, etc.and you can understand why paying off my loans became a top priority.
I quickly realized, though, that while paying off debt is a great goal it couldnt be my only goal. Even though I was years from retirement, I knew that investing early could pay off exponentially thanks to the extra years of compound interest.
That still left me to figure out how exactly to balance my long-term savings goals with getting student loans off my plate. Ultimately, as with most things, I found the answer is really about finding balance and adjusting as needed based on your current situation.
Whether you put more of your salary toward paying off your student loans or choose to invest into your retirement account, here are a few things worth keeping in mind:
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What If I Borrow From My 401 Instead
Some companies allow employees to take loans from their 401s. In many cases, this is easier and more beneficial from a tax perspective than taking a premature withdrawal, Anastasio says.
There are some benefits to this strategy. A 401 loan doesnt require a credit check or show up on your . It also comes with low interest rates . And there arent any tax consequences as long as you pay the money back on time.
There are downsides, too. You often have to pay an “origination fee” of up to $75, and sometimes additional maintenance fees. Usually, you have a max of five years to pay the loan back. After that, be ready for penalties and taxes on the remaining balance. If you leave your employer before the loan is paid off, your balance is due immediately. Meaning it’s risky to use a 401 loan to pay student loans if you don’t have job security. And again, you’ll miss out on those years of tax-deferred compounding returns that may be tough to make up for later.
It’s also worth noting that student loans issued by the federal government come with benefits and protections that other debts dont. Think: deferment and forbearance options, income-driven repayment plans, and even loan forgiveness. Replacing your student loans with debt in the form of a 401 loan would get rid of those perks. And wouldnt actually cut down the amount of debt you owe.
Why He Doesnt Recommend You Do An Early Withdrawal
Looking back, Nitzsche says that liquidating his 401 to pay off credit card debtis something he wouldnât do again.
âIt is so detrimental to your long-term financial health and your retirement,â 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 doesnât come free. Doing so has costly consequences, including both a penalty fee and taxes. For borrowers 59Â½ 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. âThat really should not have been touched and not something we would usually advise somebody to do,â Nitzsche says.
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What To Consider Before Using A 401 Loan To Repay Student Debt
Paying interest to yourself instead of to a student loan servicer probably sounds pretty great. But there are a few big things to consider before you decide a 401 loan is the right approach to getting free of student debt.
First and foremost, if you think you might leave your job, taking a 401 loan can be a bad idea because youll have to pay back the loan in full very quickly. Typically, if you quit or are fired, you have just 30 to 60 days to repay the entire loan balance. If you dont have the cash and chances are you probably dont you could end up being hit with a 10 percent penalty for early withdrawal.
If youre considering a 401 loan to pay off federal student loans, youll also have to give up a lot of important borrower protections. You could miss out on the possibility of having part of your loan balance forgiven, for example. Forgiveness is possible with federal loans if youre eligible for Public Service Loan Forgiveness or after making enough payments on an income-driven repayment plan.
And, interest on a 401 loan isnt tax deductible, whereas most borrowers are eligible to take a tax deduction for student loan interest.
Use The Debt Snowball Or Debt Avalanche Method Of Repayment
If you can afford to accelerate repayment on your student loans, consider the debt avalanche or debt snowball methods. With the debt avalanche, you target loans with the highest interest rates first and work your way down.
With the debt snowball, you go after loans with the smallest balances. The debt avalanche will save you the most money overall, but the debt snowball can feel motivating by providing you with quicker wins.
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How Do You Consolidate Student Loans
To consolidate student loans, you can combine several existing loans into one. This means you only have to make one monthly student loan payment instead of several. While there are certain requirements you must meet in order to be eligible you can start the process by applying for a Direct Consolidation Loan.
Should You Use Your 401 To Pay Off Student Loans
If you’re paying back student loans and debating using your 401 to do so, this article will help you evaluate and make the best decision.
Sarah Li Cain
Paying back student loans is no joke. Whether youre feeling the pressure of squeezing your budget to afford the payments or you want to be done with student loans forever, there are several ways to do so. Yes, you can use your 401 for student loans and for some, it looks like an attractive option, especially if you dont have much left on your loan. However, this approach may not be the best for your financial situation in the long term.
In other words, time is what will grow your retirement nest egg, and there are plenty of options to pay back your loans. Before paying off your student loans with your 401, heres a look at what you need to consider and some alternatives.
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