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Dear Penny: Should I Use My 401(k) to Pay Off My $100K Student Loan Debt?

Senior Editor

Updated October 10, 2022

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Dear Penny,

I am 29 years old with almost $100,000 in student loan debt, the majority of which is from my master’s degree. Most of my loans are federal, but I also have around $10,000 in private student loans. I’ve been consistently paying my loans since finishing grad school, but I feel like I will never pay down what I owe. I’ve also been taking advantage of the federal student loan forbearance due to COVID-19 to pay extra on the private loan.

My student loan debt is a huge source of stress and anxiety, and it impacts my ability to save for the future. Even with a comfortable salary, I live in an area with an extremely high cost of living, and I feel like I am still living paycheck to paycheck.

I have around $55,000 in my employer-sponsored 401(k), most of which is in a Roth 401(k). Since I still have 30-plus years to contribute toward my retirement savings, should I use these funds to pay toward my student loan debt? Is that even possible?

-A.

Dear A.,

It’s possible to use your 401(k) to pay off student loans. I wouldn’t recommend it, though, unless your only two choices are a 401(k) withdrawal versus defaulting, as I’ll explain shortly.

For starters, a $55,000 distribution wouldn’t translate to a $55,000 reduction in your debt. The rules for Roth 401(k) distributions are a tad complicated.

In a nutshell, any money your employer contributes actually goes into a separate pre-tax traditional 401(k). You’d owe income taxes and a 10% penalty on any withdrawals from employer-matched funds, since you’re younger than 59 ½.

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Only your contributions, plus their earnings, go into an after-tax Roth account. If you take a distribution from your Roth 401(k), the IRS will pro-rate the amount you take out between your contributions and earnings. For example, suppose you took a $50,000 distribution. If your account consisted of 80% contributions and 20% earnings, you’d owe taxes plus a 10% penalty on $10,000, or 20% of the distribution.

Then there are the lost gains. The longer your money has to compound, the less you have to save overall. Imagine if you left that $55,000 invested and never contributed an extra cent. In 30 years, you’d have about $550,000, assuming 8% annual returns. But at the end of 25 years, you’d only have about $375,000.

But there’s a larger issue that you need to consider: Is this truly a student loan problem? Or is the bigger problem that your salary doesn’t go far enough where you live?

The problem with living in a high-cost area — besides the obvious fact that (duh) everything costs more — is that even a lackluster salary looks eye-poppingly generous in most other places. As a result, you have fewer options for relief.

Income-driven repayment plans, which cap your federal loan payments at a percentage of your discretionary income, are typically a good option for someone struggling with payments. But location isn’t a factor in the discretionary income calculation unless you live in Alaska or Hawaii. Put another way, someone living in California making $70,000 a year would be expected to pay the same percentage as someone making $70,000 living in Mississippi.

Depending on your field, you should consider whether you could get a job that offers similar pay that allows you to work remotely. Whether you pursue the standard 10-year repayment schedule or income-driven repayment, those loan payments will be a lot more manageable if you’re not dealing with the costs of everything else skyrocketing.

You could also look into government or nonprofit jobs and enroll in Public Service Loan Forgiveness so your federal loans would be forgiven at the end of 10 years. Yes, the program has been rife with troubles, but those are being corrected, albeit slowly.

As companies fight to attract workers, student loan repayment assistance is becoming a popular benefit. Thanks to legislation passed in late 2020, employers can now offer up to $5,250 of repayment benefits without increasing your taxable income through 2025. That may be a benefit that’s worth prioritizing in your next job search.

In the meantime, keep doing what you’re doing by taking advantage of the pause on federal loan payments. Don’t pay a cent on your federal loans if you don’t have to until your private loan is paid off. If you’ve made federal loan payments since March 2020, you can request a refund from your servicer and apply the balance to your private loan.

I get why this is such a huge source of stress for you right now. But I also think things will gradually get easier. You’re still early in your career, so you can expect your income to rise over time. Hopefully, the jaw-dropping cost of living increases we’ve seen recently will level off at some point.

But please don’t take money out of your retirement funds unless you’re truly out of options. The payoff for sacrificing now will be worth it later on.

Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. Send your tricky money questions to [email protected].