Repay 401(k) Loan with a Student Loan?

Thank you for your question about your 401(k) loan and whether it makes sense to take out a student loan to pay it back.

Purpose of Student Loans

Student loans are designed to cover school expenses, not to pay off other debt. Still, money is fungible, meaning that it can be interchanged easily. The money you do need to pay for school would be paid for by the school loans and it is the money that the school loans freed up that would allow you to repay the 401(k) debt. In this way, you are not really borrowing the student loan money to repay the loan, even though it is only because you took the loan that you are able to repay it.

401(k) Withdrawal Penalties

It is a reasonable to be concerned about defaulting on a 401 (k) loan, as the consequences can be severe. If a person defaults on the repayment terms, the entire amount borrowed in the 401(k) loan is considered a disbursement, making it subject to 10% penalty, if the borrower is under 59½. Also, the disbursement must be declared as income, making it subject to income federal tax and state income tax in states that have an income tax. The amount owed, in the case of default, depends on how much was disbursed, as well as which income tax bracket the person is in. In the case of a large disbursement, a person can find him or herself bumped into a higher tax bracket. If this happens, the taxpayer can find that not only are there taxes owed on the disbursement, but the taxes that were withheld from paychecks may prove to be insufficient to cover taxes owed in the higher bracket.

Here are some factors that I would consider, in your circumstance.

1) What is the interest rate on the 401(k) loan and what is the interest rate on the student loans? I would be hesitant to borrow at a higher rate than I am paying now.

2) What is the likelihood that you will default on the 401(k) loan? The smaller the chance of default, the less reason to repay the debt by taking out student loans. You mentioned job loss. Are you in a less than secure position with your current employment situation?

3) What is the worst case scenario, were you to default on the 401(k) loan? How much would be owed in penalties in taxes? The greater the potential exposure to costs, the more I would be worried about defaulting on the 401(k) loan. In your case, it sounds like you are not speaking about a huge loan 401(k) loan, if the two student loans of $9,500 would pay off the debt.

4) Will you have another opportunity to take out student loans next year?

Recommendation

I would avoid taking out the student loan debt, unless I needed to do so, unless the interest rate on the student loans would be less than what I am paying on the 401(k) loan, unless I felt at great risk of being unable to repay the 401(k) loan.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com