If you want to know all there is to know about your 401K and how it relates to your student loans, continue reading.
401K Student Loan Payment Matching Bill
If you’re making payments on student loans, a new IRS bill could allow you to start saving more for retirement.
The bill—the Retirement Security and Savings Act of 2019—proposes several changes to the employee retirement plan contribution system.
Among these changes is a new provision for what’s known as 401K student loan payment matching. In short, the IRS bill would grant permission to many companies to match their employees’ student loan payments in the form of retirement plan contributions.
If you have student loan debt and you work for a company that offers 401K matching, this could be exciting news. If your company took advantage of the new ruling, you would be able to start saving for retirement where you haven’t been able to before.
What is the 401K Loan Payment Bill?
The 401K student loan payment bill came into existence after several companies individually requested special IRS permissions. They wanted to make 401K contributions to match employees’ student loan payments, which wasn’t traditionally approved by the Internal Revenue Service.
The official bill, which proposed—among other changes—making 401K student loan payment matching an option to all companies was introduced in May of 2019 by Senator Rob Portman.
The bill still has to pass the Senate and the House before it can be approved by the President and become law. To track the progress of the Retirement Security and Savings Act of 2019 (S. 1431), visit Congress.gov.
401K Student Loan Payment Rulings
A private letter from the IRS related to the first 401K student loan payment ruling was released to the public in August of 2018. The letter contained a one-off IRS ruling that applied only to the company, Abbott Laboratories.
Abbott would be allowed to make 401K contributions for employees who didn’t contribute to a 401K themselves. The company would instead consider the employees’ student loan payments as their 401K “contribution”.
Specifically, the company was approved to make 401K contributions (at 5%) for employees who were putting at least 2% of their paycheck towards student loan payments.
This initial private ruling demonstrated that the IRS was willing to grant more leeway to additional companies that wanted to do the same.
Multiple employers requested similar permissions from the IRS after Abbott Laboratories, resulting in a string of private-letter rulings.
Using Your 401k To Pay Off Student Loans
We’ve discussed the bill that could allow you to put student loan payments towards your retirement. But what about the other way around: can you use your 401K to make student loan payments?
Technically, yes. You can dip into your 401K to pay student loans. In fact, many graduates who have student loan debt do just that. A report from Merrill Lynch shows that 25% of 18- to 34-year-olds with 401K accounts have already made an early withdrawal.
The top reason cited for those early 401K withdrawals was credit card debt (31% of responses), followed by student loan debt (16% of responses). While credit card debt was the clear winner here, many young adults feel the need to take on credit card debt as a result of their already-looming student debt.
Why You Shouldn’t Use Your 401K for Student Loan Payments
Using 401K savings to make a student loan payment may result in a temporary sense of relief. However, it will also inevitably lead to more long-term stresses.
Here are some of the top reasons why you shouldn’t resort to 401K student loan payments.
Penalties and Taxes
The first reason why it’s advisable not to make early withdrawals from your 401K plan to pay your student loans is the penalties and fees you’ll face.
Since 401K contributions are pre-tax, you’ll owe federal income tax on any amount you withdraw early. You’ll also be charged a 10% early-withdrawal penalty fee. These same consequences apply to traditional IRA accounts.
Penalty-free withdrawals aren’t allowed until you turn 59 ½, with a few minor exceptions, including first-time home-buying, medical expenses, and returning to school. If you want to use 401K funds to pay for new educational expenses, you can do so without incurring the 10% penalty.
However, you’ll still need to pay income tax on whatever amount you withdraw, and this exception does not apply to repaying student loans.
Saving for Retirement
If you have a job that offers a 401K, you’re on the right track for retirement. Many graduates don’t have this benefit, which means they face the added stress of not having enough retirement savings, in addition to the stress of their student loans.
If you can stay a foot ahead in at least the retirement department, it will allow you to focus your attention on the primary problem: your student debt. If you deplete your retirement account in the attempt to pay off some of your student loan debt, you could be left with two major issues, instead of just one.
Lost Interest
Making early withdrawals from your 401K also means you’ll lose one of the major advantages of investing: earned interest. The earlier you start investing in your 401K retirement plan, and the more money you leave in the account, the more compound interest will work in your favor.
With compound interest, you earn money on the contributions you make to your 401K as they gain interest. You also earn money on the interest you’ve gained. In other words. Your 401K account earns returns, as well as returns on returns.
The more you withdraw from a 401K account, the less it will earn, both in the short-term and long term.
Contribution Matching
In the previous section, we discussed the new Senate bill that proposes 401K student loan payment matching. If the bill gets passed, your employer may decide to contribute to your 401K plan based on your student loan payments.
But until then, 401K matching is limited (unless you work for one of the few companies which have requested special permission from the IRS). To benefit from 401K matching, you have to make contributions to your 401K yourself.
If you keep making early withdrawals from your 401K, rather than adding to your retirement fund, you’ll lose out on this additional money you would be earning.
Alternatives to Using Your 401K for Student Loan Payments
Instead of using your 401K for student loan payments directly, you can use one of these strategies to put your savings to use.
401K Loans
If your employer allows it, the IRS may permit you to take out a loan from your 401K. Instead of withdrawing money directly from your 401K, you’ll be issued a loan, the amount of which will be subtracted from your account. Not all employers offer this option.
At first glance, this looks similar to simply making an early withdrawal. However, a 401K loan won’t be taxed as income, and it won’t result in a 10% penalty. A 401K loan also comes with its own set of pros and cons.
The maximum amount you can borrow with a 401K loan is $50,000 or half your 401K’s vested account balance—whichever is the lesser of the two. If you’ve been contributing to your 401K for a while, that could give you a significant amount of money to put towards your student loan payments. Some employers require a minimum 401K loan amount of $1,000.
Over the term of the loan (usually five years), you repay the principal, in addition to the interest, to your own 401K account. Since you’re essentially borrowing from yourself, you don’t need to undergo a credit check to qualify.
A 401K loan will generally have a lower interest rate than other loans, and you’re not losing the money you pay in interest. That amount is going straight into your retirement fund.
However, if you quit or are fired from your job, you’ll likely have to pay back your loan in full right away. If you’re unable to pay the total amount, you’ll be issued a penalty by the IRS.
Additionally, you can only borrow from a current 401K plan. You can’t borrow from a 401K or IRA that’s been transferred or if you no longer work for that employer.
As mentioned above, taking any money out of your 401K plan will result in lost interest. While you’re repaying the loan, you’ll have less money in your account earning compound interest.
Use 401K Savings Elsewhere
If you’re struggling to repay your student loans because of significant medical bills, divorce, buying a house for the first time, or returning to school, you can use your 401K funds to pay those expenses and free up money to pay off student loans.
All of these are exceptions to the IRS 401K early withdrawal penalty regulation, so you can withdraw money without being taxed 10% extra. However, keep in mind that the other adverse effects of withdrawing from your 401K account early still apply.
Series of Substantially Equal Payments
You can begin making withdrawals from your 401K account before the age of 59 ½ if you agree to continue making those withdrawals each and every year.
While this may sound like no problem at first, it’s actually one of the worse options for using your 401K savings to pay off debts.
The tax code for 72t early distribution allows you to take a series of specified payments each year, the size of which is based on your age and the size of your account. However, you have to keep taking the agreed-upon periodic payment for five years or until you reach the age of 59 ½ — whichever is longer.
You won’t be allowed to make larger or smaller withdrawals in that time period, and you won’t be able to forgo withdrawals if you don’t need the money. This will result in the long-term, substantial depletion of your 401K account, and it’s not a good idea if you only need short-term relief from student loans.
Rollover Bridge Loan
The final way you can use your 401K to pay student loans is by rolling the account over into a different IRA account. When you do this, you essentially withdraw all of the money and deposit it to the new account. You don’t have to make that deposit for 60 days.
However, this is the riskiest strategy. While you can do whatever you’d like with the money before you have to deposit it, you only have 60 days to regain those funds. If you take $1,000 to pay off student loan debt, you’ll need to find another $1,000 within the next couple of months.
If you don’t safely deposit the total rollover amount into an IRA once the time period is over, the IRS will treat the missing amount as an early withdrawal.
This option is only viable or useful if you have a significant loan balance due that you can’t pay off, but you know you’ll be able to regain that amount in the next 60 days.
You can only “rollover” a 401K or IRA plan once per year.
401K and Student Loan Payments
Your 401K may have more to do with your student loan payments than you might have realized. In 2019, a new bill passed promoting the idea of 401K student loan payment matching. In the future, your employer might make contributions to your 401K based on how much you’re paying on student loans.
Additionally, you can use your existing 401K funds to pay off your student debt. However, there are much better ways to go about this than making early withdrawals from your account.
With the information provided above, you have everything you need to combine your 401K and student loan payments into one strategic financial plan.
