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I have a student loan that has 6.5% interest (highest rate of many) and would be able to repay it if I took a loan on my 401k. I know the basic trade-off is that my money may do better in the 401k than 6.5%, but what other considerations should I make?

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Here is a related question that discusses using a 401k loan for a home down payment. –  Alex B Apr 4 '11 at 16:55
    
Another consideration is that if you run into serious financial trouble, your student loans might be written off in bankruptcy, but a 401k loan is a loan from yourself. 401k assets are yours to keep for retirement even during bankruptcy. –  glenviewjeff Jul 11 at 17:29

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up vote 6 down vote accepted

Here are some other things to consider:

  • You must pay the 401K loan back over a maximum of 5 years. Student loans are usually longer than this, so make sure your cash-flow can actually support the new payment timeline.
  • The repayment of a 401K loan gets deducted directly from your paycheck, which may decrease the take-home pay you're expecting. Not a deal-breaker, just something to be aware of.
  • Many 401K plans won't let you make any further 401K contributions until you've repaid the loan. You'll miss out on some valuable tax-free investing because of that, which may include your employers match. There is a large opportunity cost to borrowing this money.
  • Your long-term returns in your 401K may be lowered because you'll be breaking the dollar cost average of your contributions.
  • You still have to pay interest back to your 401K account on the money borrowed. This is usually prime + one or two percent. With prime currently at 3.25%, do the math and make sure it makes sense in terms of the interest rates.
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Is the "interest" on a 401k loan lost to the fund or does it become part of the IRA--that is, am I paying the interest to myself? –  Nick T Apr 4 '11 at 2:57
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You're actually paying the interest to yourself, so it becomes part of the 401K account. It's basically meant to discourage people from taking an interest-free loan from their account. The downside is that you'll be paying that interest back with after-tax dollars and that interest paid will then be taxed again once you withdraw it from the account during retirement. –  The Matt Apr 4 '11 at 4:17
    
Matt The tax situation only comes into play for the fact that the student loan may be a tax deduction, but the 401 loan wouldn't be. Other that that, there's no double tax. The loan itself comes tax free, and goes back pretax. –  JoeTaxpayer Apr 4 '11 at 19:53
    
You're right about the loan itself not being taxed, but the interest is double-taxed. –  The Matt Apr 5 '11 at 0:54
    
@Joe or @The Matt - Great point, I hadn't considered the double-tax on interest. Do you have any references on this treatment? –  bstpierre Apr 5 '11 at 1:33

If you leave your job (or lose it) the loan is due on separation. You'll pay tax and a10% penalty.

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Just to be specific, it's due 60 days after separation. –  The Matt Apr 4 '11 at 2:41
    
Will this occur with any change in employer? –  Nick T Apr 4 '11 at 22:22
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I've never seen a provision to transfer a 401 with a loan in place. It's an interesting thing, congress should add it ad a protection for those changing jobs. –  JoeTaxpayer Apr 4 '11 at 23:17

Don't do it! The penalty and repayment requirements of the 401K will likely be more of a headache than the student loan payments. Just pay off the student loans the normal way, or in larger chunks, if you can. Student loans often have lower interest rates than other loans.

Think of your 401k as your long term savings. Don't rob your long-term self to pay the student loans.

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