Call it the double whammy.
Many older Americans—baby boomers and GenXers—are facing a "double debt dilemma" carrying both student debt and 401(k) loans.
"To add a 401(k) loan to existing student debt is like adding insult to injury," said Alonzo Nieva, retirement plan education consultant for BOK Financial®.
And yet, it's happening more and more often.
Older borrowers who are still paying off student loans tend to have higher balances than younger borrowers—and less time to pay loans back. A recent study shows that while the average student debt for Gen Z borrowers is $27,900 and $46,400 for millennials, Gen X borrowers owe $51,400 and baby boomers $58,300.
About 30% of boomers and 32% of Gen X borrowers with student debt have also taken out a 401(k) loan, according to the study. "I think there's a lot of room for education on 401(k) loans and a lot of misunderstandings to address," said Nieva.
Short-term solutions, long-term implications
"A 401(k) loan can certainly help people get out of a bind, but it's not usually the right or best option," said Nieva, especially if you're carrying additional debt like student loans.
Many people don't fully understand how 401(k) loans work, he said. Some make decisions in a panic or at the last minute without taking the time to consider if the decision is right for them and their current financial situation.
Employees have the ability to take a loan out of their 401(k), and just like other loans, it has to be paid back. Typically, you can borrow $50,000 or 50% of your vested balance in your retirement plan, whichever is less. There's no credit check to take the withdrawal and typically no inquiries into how borrowers will use the money.
It's fast, it's easy and people often view it as free money—but that's not exactly the case.
"In this situation, you're the bank and the borrower," said Nieva. "It can be a valuable resource for some people in some situations. But the downside is opportunity cost."
Maybe you're paying yourself back 5% interest on funds that could have earned you a 10%-15% return.
"Continuously doing this will impact your overall retirement numbers," he said. "You're cutting yourself off from potentially higher returns."
The payback
Nieva said that people aren't great at self-policing and may not feel as obligated to pay themselves back in a timely manner like they would if they were borrowing from a bank.
"People are often surprised when they quit, or get laid off, and have an outstanding loan balance," he said. "If you're repaying through payroll deductions and you're no longer an employee, the employer has to collect that money from you another way."
Once you leave that employer, you have a short period of time to pay off the outstanding balance; if you don't pay it off in full in the eyes of the IRS, the remaining balance is treated as a distribution from your retirement account.
"If that happens, the remaining balance is added to your income for that year and could potentially bump you into a higher tax bracket—and then you have to pay taxes on it," he explained. What's more, if you're younger than of 59 ½, the IRS will consider your loan a distribution and may tack on a 10% penalty.
Adding in these penalties and tax implications could impact a borrower's ability to repay other debt—like student loans. For anyone considering a 401(k) loan, Nieva has some suggestions:
- Do your research. Make sure you understand how it works and the possible outcomes of borrowing.
- Have a payback plan—and deadline. Create a repayment schedule with deadlines that you know you can, and will, stick to.
- Talk to a financial advisor about other options. Explore possible alternatives to find the right fit for your situation.
"We've all been in tricky financial situations," he added. "With 401(k) loans, it's about being honest with yourself and knowing yourself well enough to know if the repayment is realistic for you and if you'll be able to make up the difference in your overall retirement contribution."
Ideally, you want to avoid carrying both kinds of debt, he said.
But, if you have both, consider chatting with a professional for insights on how the interest rates and tax implications all work together, and how to prioritize paying off the loans.
"They will have the tools and fresh perspective to help you create a repayment game plan," he said. "And they could share some financial planning resources to help reduce the risk of getting in a financial bind down the line."
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