Tap My 401K to Pay My Student Loans? Not a Chance

Someone posed the following questions to Donna Freedman at MSN Money’s Moneyblog. Although the writer wasn’t addressing me, I think the writer thought of these questions after reading about how much debt I have.

Hi Donna!
I have three questions that I thought you would be the best one to ask. Forgive me if any of them are dumb!

1) Does it not seem that it should be made legal (if it isn't), to roll one's 401k money over into student loans?

2) Is 100k the "usual" amount for an education these days? I realize that is a very broad question but it just seems that unless you're talking PHD, to end up with that much in student loans must mean living pretty high on the hog in the process. (!)
…
What say you oh money guru?!

P.S. I enjoy your articles immensely!

Initially, no, these questions aren’t dumb. And secondly, I too enjoy Donna’s articles tremendously.

Let me address question #2 first:
Is incurring $100k normal for education these days?

Answer: That depends whether you attend a state school or a private school. It would also depend what degree you’re working towards.

Using my life example:

I got my B.A. from a state school that is currently charging in-state residents $8,100 for tuition and $1,500 for textbooks for the 2008-2009 school year. (The fee for out-of-state students is $19,000.) Assuming 4 years and 4% inflation per year, a current student can expect to incur approximately $41,000 to obtain a Bachelor’s degree.

I got my post-graduate degree from a private school. According to my alma mater’s website, the annual tuition is now $37,890/year (not including student activity fees, parking, etc.) There is no estimate for textbooks but I’ll assume $1,500/year. Assuming it takes 3 years to get the degree and 4% inflation every year, a current student can expect to pay $122,959 to obtain this degree.

Keep in mind that the estimates above do not include room and board, transportation costs, etc. So, yes, it is possible to incur $100,000 for education without living “high on the hog” these days.

But…in my case my student loans are currently high as they are because I did live “high on the hog”. I would estimate that 20%-25% of my student loans were incurred to pay for living expenses in addition to tuition/textbooks. I could have worked while I was attending school to pay for my living expenses. But I chose not to since I wanted to “have fun” while attending graduate school.

Additionally, as I explained in this prior post, the combination of a low starting salary, a layoff and irresponsible spending forced me to seek several forbearances on my student loans. Although the forbearance option allowed me to postpone my monthly payments, it also meant that interest kept accruing and adding on to the principal I owed. As a result, 10 years later, I owe more on my student loans than when I graduated.

Now, returning to question #1:
Does it not seem that it should be made legal (if it isn't), to roll one's 401k money over into student loans?

Answer: A 401k participant may be able to take a “hardship withdrawal” to pay for post-secondary education for 12 months IF the participant's 401k plan allows for it. You typically need to show that you don’t have other resources to meet that need. Even if you can overcome this hurdle, the early withdrawals will be subject to applicable income taxes and a 10% early withdrawal penalty if you are younger than 59 ½.

I’m not sure if the writer was asking whether we should be able to use our 401k money to pay off student loans without penalty. My answer to that questions would be, “No.” I used to wish and pray for this type of “windfall” legislation, but not anymore.

First off, by participating in the 401k, I derived couple of tax benefits: 1.) it reduced my taxable income on the years I contributed and 2.) my returns in my 401k are tax deferred. (For the purpose of this discussion, let’s forget the fact that my 401k is losing money this year.) I’m assuming that the 10% early withdrawal penalty serves the dual purpose of discouraging me from tapping my 401k before retirement and to pay back taxes that I would have had to pay had I not participated in the 401k. Needless to say, removing this disincentive is a bad idea since it discourages saving and it robs the country of taxes that are rightfully owed.

Additionally, there are also plenty of good articles like this one that point out why people shouldn’t raid their 401ks to pay off debt, including double taxation and lost compound earnings.

But the real reason why I won’t tap my 401k even if there wasn’t a tax penalty is because I’m a true believer that when I've gotten myself into debt the old fashioned way, I need to take responsibility for it the old fashioned way by paying back the principal and interest little by little, bit by bit. The process is admittedly slow, tedious and painful. But the process has taught me the valuable lesson of how important it is to budget and live within my means.

Due to my recent commitment to tackle my debt, I’m proud to report I haven’t incurred new debt this entire year and I do not plan to either. Even my
criticized upcoming Vegas trip will be paid with cash I've earmarked as "mad money".

I realize, however, that although I won't be incurring new debt to take this trip, it's still not prudent since the money spent could be used to pay down debt or to bolster my emergency fund. Sigh. I may not always do the "right thing" financially but I am willing to pay the consequences.