Take a loan from my 401(k) to pay off my student loans?

October 22, 2012 12:46 PM

Take a loan from my 401(k) to pay off my student loans?

I've got $67,000 in student loan balance at an interest rate of 5.23%. I'm 10 years into a 30 year repayment plan.

So I've been considering taking a $50,000 (the maximum allowed) loan from my 401(k). My 401(k) charges 4.25% interest but the interest would be paid back to my account Both the principal and the interest would be paid back with after tax dollars. There is a $50 fee for loan administration that will be charged to my account annually. The payoff period would be 5 years and the payments of $900 per month would pretty much preclude my making any contributions to my 401(k) during those five years. I get a match of 3% of my salary and I'd try to figure out a way to at least contribute enough to get the match, but it would be difficult to contribute much beyond that.

Pros:
1. Debt would be paid off in five years instead of twenty
2. 4.25% of interest would be paid to me rather than 5.23% interest going to federal government

Cons:
1. If for some reason, I lose my job now, I might be eligible for a student loan deferment. If I took a loan from my 401(k) and I lose my job, I think I would either need to pay off the loan immediately or end up having a 1099 issued with the unpaid balance counted as current income on my taxes.
2. $900 monthly payments would make it difficult for me to contribute to my 401(k) beyond the 3% match. I am currently contributing more than the match.
3. I think the payment on the 401(k) loan would be taxed twice. Once when it is taken out of my paycheck and then again when I retire and take a distribution.
4. The $50 per year loan administration fee

Thoughts?

posted by bananafish to Work & Money (15 answers total)

If something bad happens and you can't repay your 401k, you are going to be hit with a massive tax bill.

I would not take money from a retirement plan unless you are doing it to avoid bankruptcy. Too much risk for a 1% savings.
posted by bensherman at 12:52 PM on October 22, 2012 [6 favorites]

Seems like a good deal, except maybe you should be sure to clear up Con#3 before you proceed.

How would you be taxed twice -- wouldn't the loan repayment simply pay off the debt. Why would you be able to take a distribution from the money you use to pay off the loan?
posted by seattlejeff at 12:53 PM on October 22, 2012

I've heard of people taking out 401k loans to pay off credit cards (with 18-24% APR), but for just the 1% difference I'm not sure it's worth it, especially with the risk of losing your job or whatever and getting hit with the early withdrawal from the 401k.

Why not just reduce your 401k contribution to the lowest possible in order to keep the match, then pay $900 extra to your student loans each month? That way you can still pay it off early, and if something happens you can skip the "extra" payment to the student loan for a month or two without any issues.
posted by Grither at 12:58 PM on October 22, 2012 [9 favorites]

Have you talked to your loan holders about possibly taking a lower, lump-sum pay off? My lenders were willing to do that (I owed about $50k, and they settled for $37k). Then I did exactly what you are planning to do, with the exception that I didn't take out a 401k loan. I just withdrew amount that I needed to pay off the loan and also pay the tax bill. The good news is that because I was paying educational expenses, I wasn't hit with the 10% early withdrawal penalty.

It was unbelievably awesome to be done with that burden, even though my 401k was decimated. However, this was 2007 and the subsequent crash made me even happier that I acted when I did. After the loan was gone I basically invested what I wasn't paying in loan payments back into my 401k, and have rebuilt my savings.
posted by kimdog at 1:06 PM on October 22, 2012

I wouldn't. If you lose your job, you have to pay the 401(k) loan all back right then and there. (whereas you can defer your student loans if you have to.)

Now, if you can do what kimdog says, pay the standard income tax on the withdrawl (and don't kid yourself, you can go from a 10% tax rate to a 37% tax rate with a $50k withdrawl) and not have to pay the penalty, I might think about it to be tax free.

But let me tell you. I've always regretted withdrawing from my 401(k) when I've done it. I've been creamed on taxes every, single, time.
posted by Ruthless Bunny at 1:12 PM on October 22, 2012 [2 favorites]

You are missing a central con: you are forgoing (potential) returns on the 401(k) balance.

The correct comparison is not the 4.25 percent vs. 5.23 percent. As you correctly note, the 4.25 percent is going to yourself, so it's not a real transfer. The correct comparison is the 5.23 percent vs. whatever the assets in the 401(k) would have earned. Since that is likely (on a risk-adjusted basis) less than 5.23 percent, that argues for taking the loan.

But I think your con #1 is also crucial. It's just very risky.

If you are currently now paying more than the 3 percent needed to get the match, instead consider dropping your contribution down to 3 percent and dedicating the extra money to your student loans.

More reading:
Just found this more detailed discussion, which summarizes what I said: "the cost of the loan is whatever administrative fees you pay plus any lost return on the assets that you’ve borrowed."

And this follow-up article discusses the tax issues and concludes they are not significant.
posted by Mr.Know-it-some at 1:15 PM on October 22, 2012 [4 favorites]

That 50k in your 401k will likely get a return higher than 4.25%. While the last 10 years feels terrible, in 2002 the S&P 500 was at 890, and today it's at 1,433.

Further, you might be getting a tax benefit today from your student loans. You will not get a similar benefit from your 401k loan.

It's a huge psychological burden. And that might be reason enough to do it. But it does not make financial sense.
posted by politikitty at 1:16 PM on October 22, 2012 [1 favorite]

I wouldn't do this, for the reasons stated above, especially the reasons of deferment later if necessary.

If you really dislike the student loans, have you considered contributing just the 3% to get the company match in the 401(k) and sending the rest of the contribution to pay off the loan?
posted by dpx.mfx at 1:59 PM on October 22, 2012 [2 favorites]

Don't borrow from your 401k. I speak from experience.
posted by infinitewindow at 2:34 PM on October 22, 2012

As Mr.Know-it-some points out, the correct comparison is "return from paying off my student loans" (5.23%) versus "return from continuing to pay into my 401k" (which you don't list).

If you are getting matching funds, then it's almost certainly better to contribute at least enough into your 401k to capture that fully--which isn't always possible if you have an outstanding loan. (Some 401k administrators will immediately route all your contributions to the loan balance, so you can't contribute to get matching funds until your loan is totally paid off.) Since a 100% return on those dollars is always going to beat the 5% return you get by paying off your loans, I would triple-check that you are actually able to continue regular, match-eligible contributions while you have a loan balance. Assuming you can do that, whether taking out that loan is advantageous depends on what you expect the market to do. I've been getting a 15% return in my 401k over the past year or two, if you are similar then you would have been MUCH worse off by pulling the money out and paying off your loan.

I considered taking out a 401k loan to increase the down payment for my house (thus avoiding a small second mortgage with a 5% interest rate) because I had the same thought process as you do--"I would way rather pay myself that money than a bank!" However, I had a very financially-savvy coworker recoil in horror at this idea, and she promptly sent me reams of research showing how much worse off in retirement people are when they take out 401k loans--basically, without the loans they would have figured out a way to contribute SOMETHING to retirement and also to their debt, but once they took out a loan they stopped saving so much and their retirement savings never recovered to the levels of those who didn't take out the loan. That was enough to convince me that it wasn't quite the great idea I thought it might be.
posted by iminurmefi at 2:36 PM on October 22, 2012

Student loan interest is tax deductible under certain circumstances. The potential forgone savings from giving up this deduction seems like something you want to consider.

I took out a 401(k) loan to help get to a larger house down payment, and would do it again in a second. The benefits in your case seem quite small, though, and if I'm right about the deductibility, are probably negative.
posted by deadweightloss at 3:10 PM on October 22, 2012 [1 favorite]

I wouldn't do it, if your goal is just to get out of student loan debt.

Also:
3. I think the payment on the 401(k) loan would be taxed twice. Once when it is taken out of my paycheck and then again when I retire and take a distribution.

Unless you are going over some maximum, the 401(k) contributions you make shouldn't be taxed. That's the point of the 401(k): tax deferred savings. You don't owe tax until you take it out.
posted by gjc at 3:51 PM on October 22, 2012

Don't do this. If you lost your job tomorrow you'd likely have about sixty days to pay back the loan in full. It's a huge risk for essentially no gain.

Borrowing from retirement is really only a good idea if you've already tapped out every typical source of funds.
posted by grudgebgon at 6:08 PM on October 22, 2012

Also:
3. I think the payment on the 401(k) loan would be taxed twice. Once when it is taken out of my paycheck and then again when I retire and take a distribution.

Unless you are going over some maximum, the 401(k) contributions you make shouldn't be taxed. That's the point of the 401(k): tax deferred savings. You don't owe tax until you take it out.

No. Con #3 on your list is correct. 401k loan repayments in indeed made with aftertax dollars (e.g., a $100 repayment decreases your take home pay by $100) and will be taxed again once you take the money out in retirement. gjc may have missed that you were talking about the 401k loan repayments and not contributions.
posted by roomwithaview at 10:02 PM on October 22, 2012 [1 favorite]

gjc was right the first time about #3. This is one of those unfortunate myths that never seems to die, perhaps because it in non-intuitive. Loan repayments are not double taxed.

Look at it this way. You take some money out of your 401(k) tax free. You put it in your pocket. Six months later you put the money back. It isn't taxed twice, even if you don't take it from the same pocket. You took money out and you put it back. You could even take it out and put it back the same day. Nothing has changed.
posted by JackFlash at 10:31 PM on October 22, 2012 [1 favorite]