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Every time an American reader writes into us with a Reader Case, our eyes bug out a little bit. Specifically, we bug out at your student debt numbers.
Americans, your student debt issues are INSANE.
Here in Canada, FIRECracker and I studied Computer Engineering at the University of Waterloo, which has a co-op program, so we paid our own way through University and we graduated with zero debt. But even if we didn’t, our total tuition for our 5 year program was around $40k, and when I briefly lost my mind and considered going to grad school, there were scholarships and grants like NSERC that would have covered it. So when Canadian readers write to us, their student debt numbers are usually in the $30k to $40k range.
But I REGULARLY get Americans writing into us with $100k, $200k worth of student debt. Hell, I personally have a relative that went to dental school in America and is currently sitting on a $500k student loan balance! And those are AMERICAN dollars, too!
So let’s spend today talking about a strategy that could help pay off your loans faster: Using your 401(k).
How Do You Pay Your Student Debt with your 401(k)?
So let’s say you’re working, you have a student loan you’re paying off, and you’re deciding whether you should put money towards making extra payments on your loan, or contributing to your company’s 401(k) plan.
If you pay down your loan, you pay less interest, which is good. But if you contribute to your 401(k), you get to participate in tax-free growth, as well as get any contribution matching your employer offers, which is also good. So what should you do?
Turns out, an option not many people know about is that many 401(k) plans allow you to loan money to yourself. It doesn’t generally require a credit check (since the lender is…you know…you), and the 401(k) plan administrator sets an interest rate on the loan which you have to pay back to yourself, generally 1% or 2% above prime.
You then take that money and pay off your student debt.
Now you’ve replaced your student loan with a loan to your own 401(k). In other words, you’ve replaced a loan to the government with a loan to yourself.
And here’s the weird part. Remember that interest rate the 401(k) plan set on the loan? You have to pay that as part of your 401(k) loan repayment. But since the interest is paid to yourself, no money has actually left your pocket. It just moved from one pocket to another.
In fact, in every other loan, a high interest rate is bad since you’re giving someone else more money. But in a 401(k) loan, a high interest rate is actually good, since it allows you to shovel more money into a tax-free retirement plan. It’s actually one of the few ways to exceed the yearly $18k contribution limit: Contribute the max, write yourself a loan with a high interest rate, then repay it plus the interest.
When NOT to Pay Your Student Debt with your 401(k)
Now, if you were to Google using your 401(k) to pay off student debt, every article out there sounds like a drug commercial: They spend 25% of the time explaining how to do it and then 75% of the time warning you about all the side effects, and there’s a reason for that. A 401(k) properly invested in low-cost Index ETFs should conservatively return 6-7% annually over a decade or so, and if you use that money to pay down debt you give that long-term growth up. So for the majority of scenarios, it makes no financial sense to do this. Specifically it doesn’t make sense to take a loan against your 401(k)…
If You Don’t Have Student Debt
If you’re thinking of using this strategy to access your 401(k) money tax-free, stop. It’s a loan, not a withdrawal. You have to pay the loan back, and you have to do it with after-tax money. So if you put pre-tax money in your 401(k), loan it to yourself, then pay the loan back with after-tax money, you’ve effectively done nothing.
To Pay Your Mortgage
Americans can take out a loan from their 401(k) to pay down their mortgage. Canadians can do this via the Home Buyers Plan (HBP) if you’re a first-time homeowner or using an RRSP mortgage if you’re not. But because mortgages are in the 3% range, it makes no sense to sacrifice 6-7% long term growth to save 3%. And for Americans, your mortgages are tax deductible so it makes even less sense.
To Pay Off High-Interest Consumer Debt
While on the surface it seems like a good idea since the interest rate on credit cards can be north of 20%, if someone’s in that much credit card debt they’re probably an idiot who can’t manage their cash flow. And the last thing you want to do for an idiot is to give them access to MORE money, because they’ll just fuck that up too.
Plus, even if the person isn’t an idiot and the debt came from something bad that happened outside their control, it makes more sense to not touch their 401(k) and declare bankruptcy. Credit card debt can be discharged, but 401(k)’s generally can’t be touched. So it makes no sense in this scenario.
If You’re Working for the Government or a Non-Profit
Doctors, lawyers, and professors, take notice! All of you are groups that tend to have very big student loans but at the same time tend to work for government or non-profits. Namely hospitals, DA offices, and universities. You guys and gals are eligible for the Public Service Loan Forgiveness Program (or PSLF), which forgives your loan after 10 years. Do that instead of raiding your 401(k).
If You’re not American
There’s a reason I called this a 401(k) loan and not a 401(k)/RRSP loan. Only Americans can do this.
But if you’re not American, this is not a reason to be jealous. At all.
While I can’t speak for every country out there, our biggest non-US audiences are Canada, the UK, and Australia. And all 3 have what I like to call “Useless Degree Escape Hatches.” That is, if you get into a ton of student debt getting a PhD in Butt Waxing and can’t find a job, there are ways to have your loan forgiven. All 3 countries I listed don’t require you to pay anything if you earn below a certain threshold, and if your income never rises, eventually the loan goes away after a certain period of time because those governments don’t want student debt to hang over your head forever.
America doesn’t have that. Even the Income-Based Repayment (IBR) plan that resembles the programs in other countries designed to help if you can’t find a high-paying job only lowers the minimum payment and prevents you from going into default. It doesn’t help pay for it, and the loan keeps compounding under IBR. And even their forgiveness program that’s supposed to forgive the loan after 20 years isn’t that forgiving, because it makes the amount forgiven taxable income, which just transfers the debt from a student loan into an IRS debt.
So while this option isn’t available to non-Americans, there are far easier ways to get out of crushing student debt for those readers. So use them.
So Who Should Do This?
The only scenario that we’ve come across in which this makes sense is the exact scenario we’ve outlined above: An American with a lot of student debt (hard to find, I know) who’s working in a for-profit company, whose company offers contribution matching.
The IRS also only allows a 401(k) loan up to $50k, or 50% of your 401(k) balance, whichever is less, so if you have >$100k loan, this strategy may only partially help. But since American student debts are graduated (meaning, every loan for every year has its own interest rate), definitely do this for at least your highest-rate loans.
And as always, double and triple check with your 401(k) plan operator and a tax professional before you implement anything. Rules may vary based on your employer’s plan.
And with that, we’re done for the week. What do you think? Is taking 401(k) loan a smart strategy for tackling your student debt? Tell us in the comments!
And for another take on this subject, Revolutionary and fellow blogger Angry Retail Banker also talks about this in his blog post Should You Use a HELOC to Pay Off Your Student Loans.
Continue onto the next article!
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Interesting! I’ve heard many times not to do this, but I suppose it could be a good option for those in the correct situation.
Seems a bit risky given that you only have 90 days to repay the full loan or include it in your taxable income for that year if you lose or change your job. I don’t think I’d do it unless I had the ability to repay within 90 days, which those using it for student loan payments likely would not. The interest rate differential on 50k invested vs. the student loan interest rate is likely not worth the risk.
I have looked at this option a couple times in the past, but my job places a cap on how much can be borrowed (I think its half of what is available). So a person would need a lot stocked up in their account. Also the interests rates are usually higher than the SL and the time to pay off is shorter than what one would normally take to pay off their SL. So it would result in a big payment.
He mentioned the cap at the end of the article and how you can still use it to pay off your higher interest rate loans.
Times when it’s not worth financially to go to college is here ! Better find a way to get a college degree outside the US or you will work your entire life to pay students debt..so what’s the point? Work for pleasure? Hell no…
Ugh, omigod that is so true. A useless degree is worse than no degree at all because of the debt that comes with it in the US.
Nice breakdown of an option that is not well known. I’m glad you put a strong emphasis on the reasons not to borrow against the 401K as well.
As a side note…
You have touched on something that is a bit of a pet peeve of mine. People who complain about their large student loan debt and act as though they are victims.
I finished grad school in the U.S. back in 2002 with total debt of $40,000. How did I do it?
1. I chose to go to a less expensive school despite having more expensive options
2. I worked part time while in school to help pay for it.
3. I didn’t borrow more than I needed and proceed to buy cars and other frivolous shit. I do indeed know people who have made large purchases with their student loans.
4. I Moved off campus and rented a room to cut my housing expenses.
I could go on, but you get the point.
I’m sure tuitions have gone up since then, but you know how much the tuition is before you apply. So don’t act so shocked and get all pissy about your huge debt as if you didn’t know it was coming. Take responsibility for your own actions and do some planning to keep the cost down.
Rant over…
Sorry to hijack. Perhaps a topic for another post? ?
Tuition was much cheaper in 2002 than it is now.
Piling on with RJ.
Worked FT and attended undergrad PT. Graduated debt free and promoted 2X while earning degree.
Went back for MBA (FT) while working FT and extensive work travel (also a member of Army Reserves at the time, so working at least one weekend per month). Graduated debt free, in middle management at mega-corp.
Retired last week with two pensions and a net worth just south of $1M (mostly index funds and a smidgen of house value).
Got an @ss load of student debt? You signed on the line. Deal with it.
Wanderer lays out several methods to pay YOUR debt. As FC would say, “Math that s#it up, and figure it out.”
Signed, department of tuff luv.
I couldn’t agree more with RJ Bruer and Red Badger. I think the problem is that a lot of people who rack up such high student debt are so young when they do it that they don’t even know any better and if they don’t have anyone to tell them how to do it then they end up screwing themselves over with bad decisions, some young people are even encouraged to make bad decisions by people who should be old enough to know better. I remember when I didn’t know what to do after graduation, my mom suggested I go to the Art Institute because she saw those stupid commercials on daytime TV “Do you like playing video games?…” “Do you like watching Saturday morning cartoons?… [then how about you pay out the ass for one of our useless degrees based on our empty promises of being able to use our industry contacts to get you a job]” I told her no because it sounded like bullshit (and even if I’d agreed with her I doubt my dad would have let that shit fly). Later on I met my spouse and he had been sucked into going to the Art Institute and his parents were completely supportive of him while he did it and encouraged him to take out a student loan to do so. Fortunately after his first year there he realized what a scam the whole thing was and stopped going so he was only just over $10k in debt rather than $30k like a friend of his that ended up going longer. This was all over 10 years ago so that school is probably a lot more expensive now. I doubt there was as much information out there as there is now on what a scam that place is so people now who suspect it is bullshit like I did can easily do some research online and find many people from branches all over north America with grievances about their experiences there.
With that being said,when my spouse was in school he met some people who would abuse the student loan system who found out that they didn’t need to pay back their loans as long as they were in school full time so they just planned on going to school forever and using their student loans to pay for their living expenses and borrowed way more than they should have been.
Aaaahahahah you guys/gals are awesome!
Yeah, I totally agree. And if we could get high schoolers to read FI blogs, I’d be yelling at them more not to get into so much debt. But they haven’t even started working yet, so why would they think about quitting their job?
The people who write to us already made the mistake, and there’s only so much good berating will do. Besides, that’s FIRECracker’s job.
Agreed. Its too bad we don’t all have wiser folks around to guide us when we are younger. I didn’t. Too be honest, I’m not really sure how I figured out that I needed to avoid tons of debt, since taking on debt seems to be the norm I’m our society. We are the weirdos here. Perhaps I’m being a bit too harsh…. Nah.
I’ve gotta agree with all of the people who recognize that the huge student loan debt isn’t entirely the fault of the young borrowers. At the risk of sounding like I’m blaming the Baby Boomers for all the world’s ills, the Mikkennials with six figure student loan debt really DID get bad advice from their elders.
We can cry “But they were 18 and legal adults!” all we want, but let’s not pretend that they were at an age where they could understand the legal ramifications of their actions.
I would also ask “So why don’t we let them drink if they’re so responsible for their actions at that age?”
Remember that at 18, the parents are still the final decision-maker in their kids’ lives, legal adulthood or not. And we’re talking a generation of HARDCORE pro-college parents who probably didn’t give their kids other options. If you think what I’m saying is ridiculous and that these legal adults (or even when they’re younger) were always free to make their own choices, then I have a thought experiment for you:
What would happen if 100 Millennial 16-19 year olds with no concrete idea of what career they want to go into (completely reasonable at that age) told their Baby Boomer parents that they didn’t want to go to college? How would those conversations end, in all honesty?
Probably with 100 new FAFSA applications.
Sincerely,
ARB–Angry Retail Banker
Well I grew up with a college fund and the impression that not going to college was not an option but when I became of age and realized how many strings were attached to the college fund (my dad thought he was going to decide my what degree I went for and then also told me if I didn’t get a 4.0 GPA or higher then he was going to make me reimburse him for tuition, all while living at “home” and having my controlling parents dictate my life with curfew and deciding if I had permission to do things and they wouldn’t be paying for college if I decided to move out and get a job to support myself) I decided I wouldn’t be going to college if I had to deal with that crap instead I moved out and let them know that if they wanted me to visit they would not be pestering me about when I was going to college or criticizing my life choices in any way. So if i couldn’t be pressured into going to college when it was going to be paid for then I’d hope there would be at least a small percentage of people who could think for themselves and not go if they had to take out a loan to do it.
I’ve said this before on a previous post about 401k loans. DO NOT DO THIS! The money you pay back with the loan is post-tax. which then gets taxed again when you withdraw in retirement. this means that if you are in the 25% tax bracket, you will pay 50% tax on that loan amount minus the small interest rate you pay yourself on the loan. A bad deal for sure.
Hello,
My current student loan debts are almost equal to my 401k balance (10k) and the same scenario for my wife.($20k) would this be a wise time to use this loan? We are mind 20’s and paid off about 45k debt in past two years.
Helpful Post! First I really appreciate the author for sharing this useful advice to pay student debt. I hope this information will be helpful to many students’ debt following the steps. As a FitMyMoney advisor, I would like to suggest this resource https://fitmymoney.com/emergency-fund/ get emergency fund to pay off their student loan debt more easily, Also you can find some different ways to pay off your student loans from this website. Best wishes to all.
Just a minor discrepancy that maybe was a typo, but there’s a lot of misunderstsnding about this. U.S. mortgages are NOT tax deductible. In the U.S., mortgage INTEREST is tax deductible, and only if you itemize your deductions.
The 2021 standard deduction is 12,550 for a single person, or $25,100 for a couple filing jointly. So your utemized deductions would have to exceed that amount to even make it worth filing that way.
$25,100 is a lot of mortgage interest.
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