With roughly $25,000 in student loan debt, Chris Herding of Portland, Oregon thought he was doing okay for himself. After graduating in 2010 with a degree in computer science, he had managed to find a well-paying job in his field and was chugging along with monthly payments on his loans.
That all changed two years later, when Herding’s employers went under, leaving him with just a small severance package and a little information regarding his employee-sponsored 401k plan. Months passed and Herding struggled to keep up with his loan payments, refusing to take the loan deferment to which a job loss entitled him.
“I was getting desperate and angry… so when a letter came in from the company holding my 401k, I wanted to make it all go away.” In a self-described “moment of desperation,” Herding researched using his 401k to pay off debt and cashed out almost all of his $40,000 savings.
In two months’ time, Herding found himself free of student loan debt and the monthly burden of his loans off of his back.
Herding’s story is not unique. Many recent graduates are now more and more concerned about carrying large student loan debts for long periods of time. While it can be tempting to dip into retirement accounts to pay off debts faster, there are many short- and long-term repercussions of doing so.
This is what you need to know before using 401k to pay off debt.
Paying it off faster: The benefits of becoming debt-free fast
According to U.S. News and World Report, the average 2014 alumni graduated with $28,110 in student loan debt. At a 6 percent rate interest rate, the publication estimates these students are shelling out roughly $312 per month on a standard payment plan. For many recent graduates, $300 or more a month can seem like a massive hurdle.
In fact, it can be so crushing that 43 percent of those with student loan debts have put off starting a family according to a study by the American Student Assistance. And sadly, 27 percent noted that it was hard to even buy basic goods.
“Not having student loans and credit card debt was like the sky opened,” said Mika Thomas, a freelance web designer who paid his loans with $22,000 of his self-funded retirement account. “I was able to think more about the future for the first time in 5 years. About 6 months after I used my Roth IRA savings, I went to Paris with my girlfriend.”
Lifestyle freedom isn’t the only reason why people should focus on paying down debt. For those with variable interest rates on debt, news of rising rates by the Federal Reserve should be a large consideration in terms of long-term value.
For example, a car loan of $25,000 at 3 percent interest has a monthly payment of $449 for a 60-month payment period. If that interest rate jumped to 3.5 percent, the monthly payment goes up to $455 per month (that’s $360 more over the life of the loan).
The larger the debt, the more significant this small percentage point increase can be for a recent graduate’s budget.
Using 401k to pay off debt
One of the most popular retirement accounts, especially with young professionals, 401ks and 403bs can be a great way to save up for later years fast. This is especially attractive if an employee is matching or making contributions.
However, 401k withdrawals before the age of 59½ mean paying a 10 percent penalty fee. In addition, the money taken out before this age will be taxed as income. You may also not withdraw money contributed by your company, only money you put in yourself.
You might also be wondering, “Can I borrow money from my IRA instead?” The same penalties and rules apply to raiding a Traditional or Roth IRA account, retirement plans particularly popular among recent graduates and the self-employed.
However, for Roth IRA accounts that are older than 5 years, your earnings are not subject to taxes, making it a good first choice if you have multiple retirement accounts to pick from.
With IRAs, there are exceptions when it comes to penalty fees. For example, if you withdraw early to pay for your first home or pay an IRS bill, you may not see that 10 percent fee.
These numbers can get tricky when you’re trying to compare options. Luckily, there are several calculators online that can help you see what your post-tax withdrawal will be and if it is worth tapping into your finances.
Borrowing from 401k to pay off debt
Outside of a withdrawal, borrowing from 401k to pay off debt is also possible. The IRS limits these loans to $50,000 or half the balance (whichever is smaller), and encourages interest rates to be set at “reasonable,” market-comparable numbers.
And with no credit checks, this may be a viable option for those who cannot refinance debt because of a low credit score.
Robert Massa, Director of Retirement for Ascende, explains further: “When the student borrows from their 401k plan account, they pay themselves back with interest. Their employer doesn’t keep the interest as some people believe; rather both the interest and the principal of the 401k plan loan are paid back into the borrower’s 401k plan account.”
Risking your retirement funds
Whether through an early withdrawal or a loan, using 401k to pay off debt is controversial, even among those in the know.
Financial expert Lorraine Decker, the author and founder of nonprofit Financial Mentors of America, isn’t convinced that using a retirement plan for debt is the right way to go, especially with lower interest debts such as public student loans.
“Never sacrifice your future to pay off a past debt,” she cautions. “You are taking funds that should be earning 7 to 8 percent tax-free to pay off debt that is probably less than 5 percent interest — and that interest is tax-deductible.”
Massa agrees. As he points out, retirement and time go hand in hand. The more time you have to contribute to your savings, the more likely you’ll be able to keep up.
“Contributions and withdrawals in your early savings years have the most impact on your final account balance in retirement. The later you start saving for retirement, the less likely you are to reach your required savings targets for a successful retirement,” Massa explains.
“Someone who waits until age 40 to start saving for retirement in a 401k plan simply cannot catch up to some who started at age 25,” he adds.
For those deciding to borrow from their 401k, it isn’t without its own unique risks. A loan that is not paid back on time each month is considered a withdrawal and subject to taxes and fees, including that 10 percent add-on for those under 59½ years old.
In addition, if you plan on borrowing be sure that you have job security. Leaving or losing your 401k-providing job will also trigger an early withdrawal.
For both Massa and Decker, paying down a debt quickly should be done with hard work and creativity. For example, Decker suggests making major lifestyle changes such as living like you did when you were in college and using the savings to pay down debt faster without cutting into retirement.
Sacrificing your retirement to pay down a debt
When Thomas decided to hit the submit button on his request to empty his Roth IRA, he wasn’t sure if it was the right decision for him.
“I still look back and wonder if I’m hurting my future,” he explained. “It was definitely risky. But once that bill was paid, I got really serious about putting that money back in my retirement and regular savings, and I’m almost there.”
The decision to raid your retirement account is a personal one with many variables to consider. Talking to a financial advisor or expert is your best bet to ensure you’re both securing your future and paying off your debt effectively.
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