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Cashing in a 401(k) to Pay Off Student Loans

Q:

If I cash out a portion of my 401(k) to pay off student loans, will I be penalized the full 10% at tax time or is there a way to get around that penalty? I do understand that there will be an immediate 20% tax withheld when I cash out regardless.


M.D.
Allen, Texas

A:

Before we determine whether the 10% penalty will apply, you should know there is a chance you will not be able to access any of the 401(k) money if the account is in your current employer’s plan.

If you are under age 59½, in order to take a 401(k) distribution with your current employer, you must be eligible for a hardship distribution, and your employer’s plan must allow such distributions. Not all do. To qualify for a hardship distribution, you must face an “immediate and heavy” financial need. The IRS has defined some such needs, including medical expenses, purchase of a principal residence, paying post-secondary tuition, or avoiding eviction. Some employers limit hardship distributions only to these scenarios explicitly approved by the IRS. Because repayment of student loans is not on that list, your employer might not permit a hardship distribution in your case. But employers can exercise a certain amount of discretion. Repaying student debt is hardly a trivial purpose, so you might qualify — especially if your debt service requirements recently have increased.

If the 401(k) is from a former employer rather than your current job, you can access the funds through two possible methods. The entire account can be distributed, but the 10% penalty will apply. The second option is to receive a series of periodic payments spread over your life expectancy. These periodic payments from a former employer’s plan are not subject to the 10% penalty, though ordinary income tax applies. This strategy probably will not provide enough money to pay off all the student loans, but may make the debt more manageable.

You might also consider a 401(k) loan. These loans are offered by most employers and avoid the 10% penalty and taxation on the withdrawal. However, employers are not required to make 401(k) loans, so you should check with your human resources department to see if this is available. A 401(k) loan allows an employee to borrow from his/her elective deferrals, but not from employer contributions or from earnings. The maximum allowable loan is the lesser of $50,000 or 50% of the 401(k) balance. If you have previously taken plan loans the calculation is more complicated. This loan must be repaid within five years unless it is used to purchase your primary residence. Interest is charged on the loan, although generally at a low rate (typically only one or two points above the prime rate.) Since you are paying the interest back to your own 401(k), you are essentially paying interest to yourself rather than to a bank.

If you take a loan and then leave your current job, you would be required to pay the remaining loan balance in full within a short time frame, usually 60 days or less. If you are unable to pay within this time frame, or if you default on the loan, you would have to pay regular taxes plus the 10% penalty on the distribution.


Answered by

Eric Meermann, CFP, AVA
Tim Bliss
December 2006

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