By AnnaMarie Mock, CFP®
Federal student loans are efficient forms of debt because the interest is tax-deductible, and the interest rates are relatively low compared to other forms of debt like credit cards. In addition, student loans are designed as an investment in yourself and provide the ability to earn more through your human capital in the future.
Using a 401(k) loan to pay off student loan debt is shifting debt sources; instead of debt to be owed to the federal government, it is debt owed to yourself in the 401(k). Although it sounds tempting, there are some compelling reasons not to utilize investment assets, specifically 401(k) loans to pay off student loans.
Opportunity Costs of Using Your 401(k) to Pay Down Student Loans
401(k)s are designed for retirement savings and provides short term benefits of a tax deduction in the year of the contribution and tax-deferred growth. Because of their long-term design, there are several opportunity costs to paying down student loans with the investment monies.
Low-interest Rate Loans:
According to the Federal Student Aid website, Direct Subsidized/ Unsubsidized undergraduate loan interest rate is 2.75%, which is fixed for the loan's life and is considered low-interest rate debt. The interest accrued is tax-deductible, which effectively lowers the rate. For example, an individual in the 22% tax bracket would be paying an effective rate of 2.15% instead of 2.75%. The interest for a 401(k) loan is never tax-deductible, and the administration fees of the loan may be higher than a conventional loan.
Future Growth:
By investing in a well-managed, diversified portfolio, an individual may achieve a higher rate of return for their investment assets above the rate of the loan.
Suppose you withdraw money from an investment account to pay off the loan. In that case, you will be eliminating the opportunity for capital appreciation, which may be projected higher than the interest rate. For example, a balanced portfolio's expected return is 6%. If someone withdraws money from an investment account or 401(k) to pay off the undergraduate loan with a 2.75% interest rate, the student would be forgoing the future growth of the assets of 3.25% more!
401(k) Loan Payback:
Regular 401k contributions are tax-deductible in the year of the contribution, reflecting a reduction in your taxable income. However, 401(k) loan repayments are made with after-tax dollars, so the loan payments are getting taxed twice - once when you're paying the loan and a second time at withdrawal during retirement. The entire 401(k) loan balance may be due within 90 days of termination from the employer. The remaining balance is considered taxable income and can significantly increase your tax bill.
Before taking action on paying down student loans, it’s essential to understand the basics of your loans. Below are some tips on getting started:
Create an inventory of your student loans and an actionable payback plan with your student loan servicer.
Be apprised of any changes in legislation that could impact your loans. The new administration may offer student loan cancellation up to a certain amount of money.
Are you eligible for forgiveness under the ‘Public Service Loan Forgiveness’ program?
If you have any questions, please feel free to reach out to the Highland team.
Author’s Bio
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.