Can You Use Your 401(k) to Pay Off Student Loans?

A 401(k) qualified employee plan allows you to save for your retirement while postponing taxes on your contributions and earnings. The money you and your employer contribute is excluded from your current taxable income, and any money earned by your contributions is not taxed until it is withdrawn from the plan. Distributions are taxed as ordinary income, and a 10-percent penalty applies to early withdrawals unless they qualify for an exception. 401k student loan repayments do not qualify for a penalty tax exception, and early withdrawals for this purpose are generally prohibited.

401(k) Distribution Rules

The income tax rate you pay on 401(k) distributions is your marginal tax bracket for ordinary income. You don’t get the benefit of long-term capital gains rates on 401(k) distributions. You must begin taking annual distributions from your 401(k) at age 70 ½. Generally, a 401(k) can make a distribution only if particular events occur. You can withdraw money penalty-free from your 401(k) until you reach age 59 ½, or if you separate from your job at age 55 or older. Otherwise, you may have to contend with the 10-percent penalty tax on early withdrawals.

Penalty Tax Rules

The 10-percent penalty applies to most early withdrawals from your 401(k). However, “safe harbor” tax regulations provide certain exceptions to the penalty tax, based on the reason behind the withdrawal. The regulations are called safe harbor because the IRS presumes any early withdrawals you make based upon them will be automatically accepted as penalty-free. For example, you won’t be hit with the penalty tax if your early withdrawal stems from a permanent disability, qualified domestic relations order (court orders stemming from separation, divorce or child support judgments), medical expenses, IRS levy, a rollover to another retirement account and certain other circumstances. If you experience any of these, you will be allowed to make an early withdrawal from your 401(k) without triggering the 10-percent penalty tax. Other financial hardships might unlock your 401(k) for an early withdrawal, but they don’t qualify for the penalty exception.

Financial Hardship

The IRS allows but does not require, an employer to make hardship distributions beyond the safe-harbor ones to employees from their 401(k) accounts, but the distribution must meet several criteria:

  • The hardship is due to heavy and immediate financial need.
  • The distribution is limited to the amount required to meet the financial need.
  • The employee has reasonably exhausted all other sources of funds.
  • The employee is barred from additional plan contributions for a six-month period.

The IRS has determined that certain circumstances automatically demonstrate heavy and immediate financial need. These circumstances include costs associated with medical expenses, home purchase or certain home repairs, educational expenses, pending eviction and funeral expenses. Even though education expenses can be considered as financial hardship, they do not include repayment of student loans. Two important facts to keep in mind regarding hardship distributions are:

  1. Not all financial hardship distributions are exempt from the 10-percent early-withdrawal penalty – only the safe-harbor ones are exempt.
  2. Not all exceptions to the 10-percent early-withdrawal penalty are due to financial hardship.

Withdrawing Your Money

Even if your employer permits you to make an early withdrawal from your 401(k), certain limitations might apply. To start with, your employer might disallow early withdrawal of any employer contributions of 401(k) matching funds. Also, some employers will not approve financial hardship distributions if they are not due to one of the safe-harbor exceptions.

Employers have some discretion when they draw up their 401(k) plans, so its best to check with your plan administrator. If your employer refuses your early-withdrawal request, you have the option of rolling over some or all of your 401(k) balance to a traditional IRA. The rollover won’t generate a current tax liability if performed as a direct transfer. The benefit of such a move is that you can withdraw from an IRA at any time, even though you might be hit by the 10-percent penalty on early withdrawals. IRAs and 401(k)s have similar, but not identical, exceptions to the penalty tax.

401(k) Student Loans

If you wish to pay off your student loans but don’t want to pay the 10-percent early-withdrawal penalty, you might consider taking a 401(k) loan. The IRS 401(k) loan rules limit the amount you can borrow from your account to no more than $50,000 or half of your vested balance, whichever is less. You will have to pay your account interest on the borrowed amount, and you must fully repay within five years, or the loan will be considered a distribution.

The Annuity Option

Another strategy to arrange an early withdrawal from your 401(k) penalty-free is through a series of substantially equal periodic payments, also known as an annuity. Under this arrangement, you take an annual payment amount determined by your life expectancy as of the first distribution year, and the amount remains the same for each subsequent year. Alternatively, you can choose the required minimum distribution method in which you predetermine the annual withdrawal amounts each year. In either case, the withdrawals must continue until you die or you completely drain your 401(k). You can use the annuity payments you receive for any purpose, including student loan repayment, without triggering the 10- percent early-withdrawal penalty.

Designated Roth Accounts

Some employers give you the option of setting up a separate designated Roth account for your traditional 401(k). You can perform in-plan Roth rollovers from your traditional account to the Roth account, but you will have to include the rollover amount in your current taxable income. The income subsequently earned by these in-plan Roth rollovers is tax-free, as are your withdrawals from the Roth account, as long as you follow IRS rules. These rules are:

  • You can withdraw your contributions at any time without tax or penalty.
  • You will pay a 10-percent early-withdrawal-penalty tax on any earnings (but not contributions) from the designated Roth account that you withdraw within five years of the in-plan rollover into the Roth account. There are no exceptions to this penalty.
  • You might have to pay a penalty on the early withdrawal of earnings (but not contributions) after the five-year period has elapsed. In general, the same rules and exceptions regarding the early-withdrawal penalty apply to earnings withdrawals from in-plan Roth accounts before age 59 ½ and early withdrawals from a traditional 401(k) account.
  • The IRS rules for multiple withdrawals from an in-plan Roth account are complex. They are described in IRS Publication 575, Pension and Annuity Income.

Consequences of Early Withdrawals

Beyond the taxes and penalties you might trigger by making an early withdrawal from your 401(k), 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 can’t replenish the withdrawn money. That is, the same annual limit on your 401(k) contributions applies whether or not you’ve 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(k) loan instead of an early withdrawal, but keep in mind that the interest on student loans is tax deductible. You’ll have to consider whether it makes sense to give up the student loan interest tax-deduction in favor of non-deductible 401(k) loan interest that you must pay to your account.

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