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Financial expert Michelle Singletary answers questions about personal finance and the economy.
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Tapping 401K to Pay Off Student Loans
Q: I have two law school loans that total about $40,000. About $25,000 of this debt is a private loan, and the remaining amount is a federal loan.
I worked while I was in law school to pay down most of my debt and, through the company I worked for, I was able to set up a 401K plan, which is now worth $14,000. I have not pursued a legal career and have taken a serious pay cut to pursue my dreams. I am, just barely, able to make the monthly payments (the interest rate on the private loan is 11%. Yikes!). My question is should I tap into my 401K to pay off some of these loans?
A: No, you should not tap your 401K to pay off some of the loans. First, if you withdraw the money from your retirement fund before you are 59, you risk a hefty 10% penalty for early withdrawal, unless you qualify for an exemption. Additionally, you have to pay federal, state and local income taxes on the money taken out. If you take the total of penalty and taxes, in the end, you won't have much to put toward the student loans, given that you only have $14,000 in your 401K. You could lose 30% to 40% of the money you've saved thus far.
You may qualify for an exemption from the 10% penalty if you are disabled or to pay medical expenses that are greater than 7.5% of your adjusted gross income. To find out about other hardship exemptions go to 401khelpcenter.com.
But you aren't in a hardship. You have an income problem.
So, my question is why aren't you using that expensive law degree? To me, that's like borrowing $40,000 - $50,000 to buy a luxury car, and now you're letting it sit in the driveway unused because you decide you'd rather catch the bus.
If you want to get out of this mess, you may have to forgo your dreams and pay your debts. How did you think you were going to pay the student loans back?
It's time to make some tough choices and "just barely" making it when you have a law degree is irresponsible. Use that knowledge you've obtained and bail yourself out without robbing your retirement fund.
After you get rid of the student loans, you can then pursue your passion debt-free.