401K loan to pay off a student loan

[Guest DCMC]

I am currently considering a 401K loan. I'm not sure if it's a good idea. I've read mixed reviews.

I am paying a student loan of $18,000 at 8.5% interest. I have other loans as well, but they are at a more reasonable interest rate.

I can take a 401K loan out at 4.5% and use that money to pay off my student loan. It seems like I would be saving money each month by paying 4.5% interest instead of 8.5%, right? And I'd be paying the interest to myself, instead of my lender, correct? (Minus the $10 fee to my 401K company). I realize there's an opportunity cost to taking money out of my 401K, but I've heard other people say that they actually grew their 401K by doing this.

Any thoughts?

[K2retire]

Your analysis of the interest savings is correct. Whether or not it grows your 401(k) will depend on whether your other investments in the plan would have earned more or less than 4.5% during that period. There is also a risk that the loan could be defaulted and become taxable if you change jobs.

[Guest DCMC]

Hmmm. But the questions is- Wouldn't I be losing the returns I'd be making on the money I took out? Is that worth it to save 4% interest? Or am I really saving 8.5% interest because I'm paying the interest to myself instead of the student loan company?

When I look at my investment portfolio online for my 401K, it says my personal rate of return is 16.92% for 1 year. If that's true, then wouldn't the 401K loan be MORE expensive? Because I'd be losing the 16.92% return on investment?

I'm confused by this. A 17% return on investment sounds astronaumical to me. It says I have a 3 month return on investment of 1.64%, but then it says 16.92% for 1 year. That doesn't add up. Am I misunderstanding my statement?

[Guest DCMC]

Also, another question about doing this-

Another way I could pay off the student loan is to liquidate some of my stock portfolio, but I don't want to do this because last time I did this it was reported as capital gains, it inflated my gross income for the year, and I ended up owing the IRS a bunch of money. I can only claim $2500 a year in student loan interest, even though I pay much more than that.

If I take the $18,000 out of my 401K, will it be reported as income or capital gains? If so, I probably won't be able to afford the taxes on it.

[GMK]

You are reading the statement correctly. During the most recent 3 months your investments returned 1.64%. Over the past year, they returned 16.92%, which means they did better during the first 9 months than during the last 3 months. This is not uncommon.

Distributions from the 401(k) are taxed as ordinary income and are subject to mandatory 20% federal withholding. You may also owe a 10% penalty tax for withdrawals before age 59-1/2.

[Guest DCMC]

OK. So, if I'm understanding you correctly, it is NOT in my best interest to take the 401K loan. I should just keep paying the student loan at 8.5% interest, yes? Because I'd be saving 8.5% in interest, but losing almost 17% in returns? So it would actually cost me 8% instead of saving me 8.5%, correct?

Also, the $18,000 would be reported as income, so I'd have to pay taxes on it? Currently I have a household income of about 95K. (We live in DC, it doesn't go as far as you'd think) Adding 18K to that would likely put us into a higher tax bracket, correct? That's what happened to us last year when we sold stock to pay some bills and medical expenses. Oy. It's impossible to get ahead...

[Lou S.]

The loan is NOT income unless you default. You are losing if your returns in the 401(k) plan remain at 17% which is well above the historical average return for the stock market. It's not what you should expect on an annual basis.

Also factor in whether or not your student loan interest is tax deductible, I'm not a CPA and don't have student loan debt so I really don't know if it is or not. If it is your effective interest rate is lower than 8.5% based on your tax savings.

If you can make the 401(k) loan payments w/o reducing your 401(k) contributions and you are reasonably confidnet that you are going to be at your current job for the next 5 years, you may be better off with the 401(k) loan that the student loan.

If you're planning on changing jobs in the near future, I'd avoid the 401(k) loan.

edit - and as always free advice is worth what you pay for it.

[masteff]

Been a while since I had student loan but my first suggestion is to see if you can move them some place else, such as to Sallie Mae.

And I'll point out to be careful of your wording... "take money out" and "take a loan out" can mean to different things: a taxable distribution vs a non-taxable loan.

[ESOP Guy]

Taking a distribution that is taxable at your age is a very expensive thing to do.

Let me ask you this question.

How much are you putting into the 401(k) plan as a percentage?

At what level does your employer match?

The point I am getting at is it worth it to reduce the amount you are putting into the 401(k) down to the level where you employer stops matching and use that saving to make an extra payment on the loan?

For example:

Your employer matches 50% of the first 6% of pay. You are currently putting 8% of pay. Reduce your deferral rate to 6% to get the match. And take the 2% of pay to make extra payments on the student loan.

This allows you to get the full match which is valuable. It allows you to keep what is in the 401(k) fully invested. The only taxes you pay are the regular income taxes on the 2% you are no longer putting in the 401(k) but at least you aren't paying any excise tax on early withdrawal. You are not at risk if you lose your job of having a 401(k) loan becoming a taxable distributions.

Maybe the fact set doesn't fit you but it might be worth to get some advice from a paid professional after they have looked at all of your information and have a better idea of all the facts.

[Guest DCMC]

To answer some of the questions above:

1.) I can deduct the interest on my student loans, but only $2500 a year. If I pay this loan off entirely, I'll still be maxing out my deduction on my other lower interest loans.

2.) My loans are already at Sallie Mae. I have some loans at 4.5% and just this one loan at 8.5%

3.) I work in a hospital. As long as people get sick, I'll have a job. Also, if for some reason we DO have layoffs, I could repay the loan by selling stock. I'm just reluctant to do that because I don't want to pay capital gains tax, plus I'm saving that money for a downpayment on a house.

4.) I contribute 11% to my 401K, which is well above what my employer matches. The reason for contributing so much is that I didn't work (or contribute to retirement savings) for a long time because I was in graduate school. I only started a 401K in my late 20s, so I'm trying desperately to catch up.

5.) I can afford to keep paying the loan at 8.5% and contributing to my 401K at 11%, but that leaves me very little disposable income, and I end up putting medical expenses/car repairs on high interest credit cards. (But those emergencies don't come up all that frequently).

I guess I just thought- If my 401K earns less or equal to 4.5% anyways, then I'd be saving money every month by not paying the 8.5% interest on the student loan. Either way I'm going to be repaying this loan for the next 5 years- either repaying to my 401K or to Sallie Mae. I'm just trying to decide which is in my best interest to pay.

[BG5150]

I can take a 401K loan out at 4.5% and use that money to pay off my student loan. It seems like I would be saving money each month by paying 4.5% interest instead of 8.5%, right? And I'd be paying the interest to myself, instead of my lender, correct? (Minus the $10 fee to my 401K company). I realize there's an opportunity cost to taking money out of my 401K, but I've heard other people say that they actually grew their 401K by doing this.

Any thoughts?

The way you grow your 401(K) loan is if by some stroke of luck, the cost of the shares you are buying back are less than the cost of the shares when they were liquidated.

In this yo-yo market, are you willing to take that chance?

[BG5150]

To answer some of the questions above:

3.) I work in a hospital. As long as people get sick, I'll have a job.

Hospitals close all the time. Or reduce staff.

So if your position gets eliminated, you get terminated and the loan comes due. It doesn't matter if you find a new job the next day. (Chances are, any new plan you get into will not accept a rollover of the current loan) If you can't pay it back, you owe taxes on the outstanding amount. Plus a 10% penalty tax on top of that.

[Guest DCMC]

OK, all this info has been very helpful.

So, it sounds like based on this info- I'm better off NOT taking the 401K loan and just continuing to pay the student loan at 8.5% because the 401K is performing above average right now. If the 401K performace dips below 8.5% it would be more advantageous to take the 401K loan and pay off the student loan. I'm not super worried about losing my job, but if that did happen I'd be able to repay the 401K loan by selling stock- with of course the penalty being that I'd have to pay capital gains tax and I wouldn't have as much for a house downpayment.

My husband also suggested lowering my 401K contributions, but with the 401K performing at 17%, I think I'd rather keep my contributions high while I play catch up and try to make cutbacks elsewhere like cancelling my cable or moving into a smaller apartment while I save up for a house.

[MWeddell]

Just because your account in the 401(k) plan has a 17% rate of return during some recent time period does not mean it is likely to return that much in the future. As you may have heard, past performance is not a guarantee of future performance.

[John Feldt ERPA CPC QPA]

If job security is not an issue, then the best time to take out a loan from your 401(k) or 403(b) plan is right before your plan investments drop due to a market decline. The loan repayments will be buying back into the market when the market is lower. The worst time to take out a loan from the plan is when your investments in the plan are about to enjoy some really great gains. Simple math. The tax deductible nature of the loan interest looks like it is not much of a factor in your particular case.

So, now if you could predict the future . . . but then you would not likely need a loan for anything if that were true!

So, yes, you are right that repaying a plan loan is paying the interest back to your own account instead of to the loan institution. If you feel the payment terms can be handled and you won't need a forebearance waiver for job issues and your job is secure, then it could be reasonable to take the loan from the plan to pay off another loan outside the plan. However, the future is an unknown, so you'll have to make the determination as to what you think makes the most sense for your situation.

[BG5150]

Don't forget, that the $18,000 loan is payable in 5 years max. I'm not sure what the window is on your student loan.

It's about $340/month, or $170 every semi-monthly paycheck at 5.25% interest. (We use prime +2)

[jpod]

My 2 cents.

1. Get the 17% 401k return out of your head. It won't last. Starting today you can lose 17% over the next year (or two or more).

2. By taking a plan loan to pay off the student loan, you are saving the full 8.5%, not merely 4.0%. The reason being that you are paying it to yourself. If you were able to deduct any part of the 8.5% interest you are paying on the student loan, the trade-off may be different, but I doubt very much you can deduct the student loan interest.

3. Therefore, by taking the plan loan to pay off the student loan you are making an investment that is guaranteed to yield 8.5% year on the declining balance of the plan loan. This seems like a no-brainer to me. If you lose your job and the plan loan becomes due you can go borrow money from another source to pay off the plan loan and avoid the tax hit on a loan default if that makes the most sense at the time.