Paying off debt gives you more bandwidth to save for retirement. Using your retirement savings to pay off debt deprives you of compounded returns on the funds you use. Use your retirement calculator to see what that looks like. Weigh the advantages of being debt free against the short-term losses of depleting your 401(k) fund. We’ll examine that further in this article.
Taxes and penalties for early withdrawals
Retirement savings accounts like 401(k)s are built with tax-deferred contributions deducted from your salary. They’re not meant to be withdrawn until you turn 59 ½ years old. Taking those funds out before that will trigger a 10% penalty from the IRS unless you complete a 401k rollover to an IRA. You’ll also need to pay income taxes on the money you withdraw. Use the chart below to check your current tax rate.
| Tax Bracket | Individual Income | Married Filing Jointly Income |
| 10% | $11,000 or less | $22,000 or less |
| 12% | $11,001 to $44,725 | $22,001 to $89,450 |
| 22% | $44,726 to $$95,375 | $89,451 to $190,750 |
| 24% | $95,376 to $182,100 | $190,751 to $364,200 |
| 32% | $182,101 to $231,250 | $364,201 to $462,500 |
| 35% | $231,251 to $578,125 | $462,501 to $693,750 |
| 37% | $578,126 or more | $693,751 or more |
Let’s say you’re making $125,000 per year, and you withdraw $50,000 from your 401(k) to pay off student loans. That increases your annual income to $175,000, which is a 24% tax bracket. The penalty on the $50,000 is $5,000 (10%), and the tax is $12,000 (24%), leaving just $33,000 to apply to your student loans. That’s an expensive way to pay off debt.
The second part of this to look at is the lost opportunity cost. Historically, 401(k) accounts produce a 5% to 8% return over twenty years. Withdrawing $50,000 could cost you as much as $4,000 in the first year. Compounded returns of 8% over twenty years could turn that $50,000 into just north of $233,000. That’s what you’ll lose if you take the money out now.
Cost versus value of 401(k) loans
Some 401(k) providers allow you to borrow funds without incurring the early withdrawal penalty or tax liability. Using the same scenario as above, that means you can use the entire $50,000 to pay off student loans, but you’ll pay an interest rate of 5% to 8% on the 401(k) loan. If you carry federal student loan debt, that’s comparable to what you already pay.
The numbers are slightly better if you’re looking to pay off private student loan debt that could carry an interest rate of up to 16%. The 401(k) loan could be significantly cheaper, saving you thousands of dollars annually. Of course, you’ll still face the opportunity cost of lost returns, so do the math carefully before choosing this option.
In most cases, a 401(k) loan should be a last resort to be used only when you’re in danger of defaulting on your student loan. Look into student loan forbearance and forgiveness programs before withdrawing your retirement savings. The Biden administration has been working on several options in this area to make some relief available to you.
The Bottom Line
Withdrawing funds from your 401(k) before age 59 ½ will incur a 10% penalty and a tax liability. Borrowing your 401(k) funds is penalty and tax-free, but the average interest rate for a 401(k) loan is 5% to 8%, roughly the same interest you’re paying on your federal student loan. Combined with the opportunity cost of lost compounded returns, neither option is cost-effective. Using your retirement funds early should only be done in an emergency.