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Sometimes a smart financial move can seem almost too good to be true, like taking out a 0% APR balance transfer credit card to pay off your high interest credit card debt.
But is withdrawing from your retirement account to pay off your student loans the same kind of trick?
Last year the Congress relaxed the rules on 401 (k) and Individual Retirement Account (IRA) withdrawals, making it easier for investors to withdraw money from their retirement accounts. For student loan borrowers, is it time to cash in your 401 (k) and get debt free?
Before you plunder your nest egg, read on to learn about some possible consequences you might face and the alternatives you should consider instead.
Risks of using a 401 (k) withdrawal
If you have money in a 401 (k), you are allowed to remove it. But there are major downsides to cashing in your 401 (k) before retirement.
You will owe taxes and fees
Whether you have a traditional or a Roth 401 (k), you will have to pay a 10% penalty on withdrawals if you are under 59 1/2. You will also owe income taxes on withdrawals from a traditional 401 (k), depending on your current tax bracket. If you made your first contributions to a Roth 401 (k) at least five years ago, all withdrawals are exempt from income tax. Otherwise, you may owe tax on your investment earnings.
You will lose potential gains
One of the main disadvantages of early withdrawals from your 401 (k) is the loss of future compound interest. When you take money out of your investments, you lose all future income.
Let’s say someone in the 22% tax bracket withdraws $ 10,000 from their 401 (k) to pay off their student loans. They would end up paying $ 2,200 in taxes to the IRS at tax time, plus a 10% early withdrawal penalty of $ 1,000.
It may sound bad, but it gets even worse when you consider the long term consequences.
“This current cost is high, but not as high as the opportunity cost,” said Ben Wacek, founder and senior financial planner of Guide Financial Planning in Minneapolis. “If you had left that $ 10,000 in the account for the next 40 years to increase by 8%, you would end up with over $ 217,000.”
What to do instead of making a 401 (k) withdrawal
Using your 401 (k) money should be a last resort. Here are some options to explore before reaching this point:
Request a loan deferral
There are different deferral programs for specific circumstances. They include:
- Postponement of cancer treatment
- Postponement of economic difficulties
- Postponement of graduate scholarships
- School postponement
- Military service and postponement of students after active service
- Deferral of the borrower Parent PLUS
- Postponement of rehabilitation training
- Postponement of unemployment
If you have the following types of loans, interest will not accrue during the deferral:
Interest will accrue if you have any other type of federal loan. When the deferment period is over, all accrued interest will be capitalized, meaning it will be added to the principal balance.
This will increase your total balance and your monthly payments can now be higher than they were before. You can also end up paying more interest during the life of the loan. That is why you should not defer loans unless you risk default.
You can request a deferral online via Federal student aid via the specific program to which you are eligible. If you don’t qualify for a stay, your next best option is to apply for forbearance.
Request for abstention
Borrowers with federal loans have access to abstention, which is similar to adjournment. The main difference is that interest will always accrue while your loans are in forbearance, no matter what type of loan you have. All types of federal loans are eligible for forbearance.
You usually need to prove that you are having difficulty making payments to be eligible for forbearance. You may be asked to show proof of unemployment or financial hardship, such as your bank statements or pay stubs. Receiving food stamps or other form of government assistance may also matter.
Forbearance is manually approved and granted for one year at a time. You can renew it for a total of three years.
You can make interest payments only during the forbearance period if you want to avoid interest being capitalized at the end of the forbearance period. Interest will not capitalize on Perkins loans.
Many private lenders offer their own forbearance programs, and the time frame depends on the specific lender and their restrictions. For example, CommonBond offers a 24-month opt-out program. SoFi offers a 12-month forbearance program and also provides employment counseling to unemployed borrowers.
Contact your private lender and find out about your forbearance options. You may need to reapply as often as every month to remain eligible.
Switch to an income-based repayment plan
The federal government offers income-based reimbursement (IDR) for borrowers with direct loans. If you have FFEL or Perkins loans, you can consolidate them into a direct consolidation loan to become eligible for income-tested reimbursement.
Income-based repayment plans base the monthly payment on your income and the size of your family. Depending on your salary and the number of dependents, you may see a drastic difference in your monthly payments.
Let’s say you are not married, earn $ 50,000 a year, and have two children. You also owe $ 30,000 in student loans. Under the revised Pay As You Earn (REFUND) plan, which calculates your monthly payment based on 10% of your discretionary income, your monthly payment would increase from $ 286 per month to $ 145 per month.
These repayment plans also come with a loan remission advantage. You usually have to make 20 or 25 years of payments, after which the loan balance is written off. You will owe taxes on the amount handed over. The timeframe depends on the type of IDR plan you choose, the type of loans you have, and when you graduated.
You can apply for an IDR plan even if you are unemployed. In this case, you would have a monthly payment of $ 0. Borrowers may be better off with IDR instead of deferral or forbearance, as those $ 0 monthly payments will still count toward loan cancellation.
You can apply for an income-based repayment plan at any time. You are required to certify your income once a year, but you can also resubmit your application at any time. For example, if your working hours are reduced, you can resend your form so that your payments will decrease.
Refinance private loans
If you have private student loans, you can refinance them based on your current situation. If you have cash flow issues, you can refinance them for a longer term, as long as you meet the requirements of the lender. This will lower your monthly payment and free up more money for other needs. One of the possible disadvantages of choosing a longer term loan is that you might end up paying more total interest over the life of the loan.
If you want to pay off your loans faster, you can refinancing at a lower interest rate. It can also reduce your monthly payment. But if you can afford to pay the same amount you paid before refinancing, you’ll pay off the loan faster and save on interest at the same time.
Borrowers with federal loans should be wary of refinancing, as they will lose all of the benefits associated with federal loans, including income-tested repayment, deferral, and generous forbearance options.
Contact the lender
If you’ve exhausted all of your options and are still struggling to afford student loan payments, contact your lender. They may have special programs that you did not apply for, such as plans to reduce interest rates or payments, or be willing to defer your loans for a longer period.
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