Can I Use My IRA to Pay Off Student Loans?

 February 28, 2022
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If you’re facing a burdensome amount of student debt, you might be considering withdrawing from your retirement savings to pay off your loans. While you technically can use your IRA to pay off student loans, this move isn’t recommended.

Withdrawing from your savings before you’re 59½ might cost you in penalties and fees. What’s more, draining your retirement funds could jeopardize your financial future.

That said, the rules around early withdrawals vary depending on whether you hold a traditional or Roth IRA or 401(k). Read on for what you need to know before deciding to do this.

Plus:

Using a traditional IRA to pay off student loans

An independent retirement account (IRA) 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 you’ve reached the age of 59½. But if you withdraw that money earlier, whether to pay off student loans or something else, you’ll 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 won’t be charged this fee if you’re unable to earn an income due to a total and permanent disability.

Unless you’re exempt, however, you’ll 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, you’ll probably find that this approach isn’t worth the extra costs.

Using a Roth IRA to pay off student loans

If you have a Roth IRA, you can withdraw the money you’ve contributed at any time without penalty. Unlike with a traditional IRA, you’ve already paid taxes on the contributed amount, so you won’t get taxed again after you withdraw.

However, you will get charged a penalty if you try to withdraw any of the earnings you’ve gained on your contributions. In other words, you can withdraw up to the amount you’ve contributed to your Roth IRA at any time, but if you try to take out more, you’ll be liable for the 10% penalty.

If you’re at least 59½, however, you can withdraw your Roth contributions and earnings without penalty, as long as you’ve held your account for at least five years.

Using a 401(k) to pay off student loans

A 401(k) works similarly to an IRA, but it’s offered by your employer. Some employers offer both traditional 401(k)s, to which you contribute pre-tax dollars, and Roth 401(k)s, to which you contribute after-tax dollars.

If you withdraw money from a traditional 401(k) before you’re 59½, you’ll have to pay a 10% penalty plus income tax. But if you make early withdrawals from a Roth 401(k), you won’t have to pay a penalty, as long as you’re taking out your contributions and not your earnings.

Some 401(k) plans also allow you to borrow a 401(k) loan. The interest rates on 401(k) loans tend to be low, making this a relatively affordable borrowing option. However, you’ll miss out on the earnings you could be getting on your retirement savings.

What’s more, borrowing a 401(k) loan can be risky, since if you leave your employer while you’re still paying back your loan, you’ll likely need to pay it back immediately and in full. If you can’t afford to pay it back, the amount will be treated as an early withdrawal, which may incur taxes and fees.

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.

Let’s say your normal income tax rate is 24%. With the 10% penalty you could get on an early withdrawal, you’ll essentially be paying 34% of your distribution. If you withdrew $10,000 from your IRA early to pay off your student loans, you’ll owe $3,400 in taxes and fees.

What’s 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, you’ll 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 you’ll pay even more taxes than normal.

Now let’s say that you kept that $10,000 in your retirement savings account. If you got a 7% annual rate of return, you’d have about $19,672 in your account after 10 years. After 20 years, you’d have $38,697 in your account.

This is assuming that you don’t make additional contributions to your IRA or 401(k). If you keep saving money in your retirement account, you’ll 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, you’ll miss out on those earnings.

Withdrawing from retirement to cover qualified education expenses

While there are no special rules that allow you to put retirement savings toward student loan debt, you can withdraw from your retirement account fee-free if you use the money to pay for qualified higher education expenses. These qualifying expenses include tuition and fees, books, supplies and equipment.

But while the 10% tax penalty is waived, you might still have to pay income tax on your plan distributions, unless you hold a Roth account. Plus, keep in mind that draining your retirement savings could endanger your future financial health.

Alternative ways to manage your student loans

Before borrowing from your IRA or other retirement savings to pay off student loans, explore alternative options for managing your loans. Here are some repayment options and strategies that might help:

Apply for income-driven repayment

If you hold federal student loans, consider applying for one of the four income-driven repayment plans:

*This is the only plan available for parent PLUS loans

All of these plans adjust your monthly payment to 10%, 15% or 20% of your discretionary income while extending your loan term to 20 or 25 years. If you still have a balance at the end of your term, it will be forgiven.

Income-driven plans can be a great way to make your student loan payments more affordable. Depending on your financial situation, your payments on an income-driven plan could be as low as $0.

Request deferment or forbearance

Another option for federal — and some private — student loans is deferment or forbearance. Both of these options pause your loan payments temporarily if you’re experiencing financial hardship, have gone back to school or have another qualifying reason.

The downside of postponing your loan payments, however, is that your balance will likely continue to grow due to interest charges. The only exception is subsidized loans, which don’t accrue interest during deferment.

But for all other loan types, pausing payments through deferment or forbearance could be a temporary Band-Aid, rather than a long-term solution.

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.

Keep track of your monthly budget

While the importance of budgeting your money might be old news, it can be helpful to track your income and expenses when you have student loan debt. Whether you use a spreadsheet or a budget-tracking app, getting a handle on your monthly cash flow can help you earmark money for your student loan bills.

You might identify areas where you can cut down on spending or feel inspired to earn more money with a side hustle.

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.

Think twice before borrowing from your IRA to pay your student loans

In the end, the cost of borrowing from your IRA to pay off student loans could outweigh the benefits. Not only will you have to consider taxes and fees, but you might miss out on the earnings you could get from investing your money.

While it might be tempting to pay off your student loans early, think carefully about the best way to balance saving for retirement with getting rid of your debt. If the interest you’re spending on your student loans is lower than the interest you expect to earn on your investments, it could make sense to prioritize investing over paying off your student loans early.