The cost of acquiring post-secondary education has skyrocketed in recent decades. According to a report by CNBC, the average tuition and fees for a private nonprofit four-year college is nearly $40,000. Students are taking on more debt than ever to meet these astronomical costs. As noted in the article, Americans now owe over $1.7 trillion for their education and prices are not going down.
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On average, undergraduate graduates graduate with nearly $30,000 in student loan debt. Monthly payments on these loans can range from $100 to $300 or more. For those with masters or doctoral degrees, payments can easily exceed $1,000 each month.
Undoubtedly, graduates are drowning in debt. Given these stark realities, should you be using your 401(k) to pay off your student loans?
Face the facts
Before you withdraw money from your 401(k), you need to know the facts. If you’re not of retirement age (59½), you’ll likely face a penalty if you opt out of your 401(k). As determined by the Internal Revenue Service (IRS), early distributions from a pension plan may result in a 10% penalty unless an exception applies. You may also have to pay income (state and federal, depending on where you live) on the amount you earn.
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If the weight of your student loans is weighing you down, you may need to consider several alternatives before accepting the penalty and taxes associated with paying off your 401(k) early. As such, using your 401(k) to pay off your student loan is not a wise choice unless you are seriously insolvent or at least 59 ½ years old.
exceptions to the rule
As with anything in life, there are a few exceptions to keep in mind. For example, you may be entitled to a hardship deduction. A hardship distribution doesn’t allow you to borrow money to pay off your student loan, but can be used if you have an “immediate and significant financial need.”
According to the IRS, tuition to cover your education fees, as well as room and board costs, covers the immediate and heavy financial burden. You can also use a hardship distribution to cover post-secondary education costs for your spouse, children, dependents, or beneficiaries.
Again, a hardship distribution cannot be used to pay off student loan debt already incurred, but it can be used to pay tuition for the coming 12 months. Also, some pension plans do not allow for hardship distribution.
Borrowing could be better
If you’re financially strained but have a healthy 401(k), you might want to consider taking out a loan for your retirement plan. According to the IRS, Individual Retirement Accounts (IRAs) and IRA-based plans cannot offer credit.
To borrow against your 401(k), you must first ensure that your plan offers credit to participants. Then be sure to read the fine print. There may be a minimum and a maximum to how much you can borrow. In general, you can get a loan of up to 50% of your vested benefits account balance, up to $50,000. Also, in most cases, you have to pay back your loan within five years, which means you could have higher payments.
Consider your options
Long story short, before accepting the penalty, consider other options instead of retiring from your 401(k). Even if it’s healthy, you’re doing yourself a disservice. Not only do you pay a lot to withdraw the money, but you also lose potential earnings. You lose compound interest that turns your modest sum into a large nest egg until your retirement.
Consider the alternatives
Now that you understand why it’s not a good idea to take an early exit from your 401(k) to pay off your student loans, let’s discuss other ways to pay off your loans. Depending on the nature of your loan, you can ask for leniency or forgiveness. State and federal programs can help you pay off the outstanding debt, especially if you’ve decided to pursue a career in public service.
If you have federal student loans that are large relative to your income, you may be eligible for an “income-related repayment plan.” An income-related amortization schedule can significantly reduce your student loan.
You can also contact your lender directly to see if they will work with you on payments. Explain why you need a forbearance on your loans and be ready to support it. If you have a personal loan with a high interest rate, you might consider refinancing. All of these options may be preferable given the short- and long-term negative effects of paying off your 401(k) early.
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This article originally appeared on GOBankingRates.com: Should You Use Your 401(k) to Pay Off Student Loans?