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Should I cash out my 401(k) to pay off my student loans?

January 9, 2012: 6:06 AM ET

I graduated in May with a master's degree, but I am currently unable to find full time work in my field. Soon I will be on the hook for my first student loan payment of $628 a month and I will have 10 years of payments. Because I am only working part time, I will not be able to cover that payment along with my other living expenses. Should I cash out my 401k from a former job? It is worth about $46,000 right now, and that would almost cover all of my student loans. —Name withheld, Boston

While it's tempting to consider using retirement funds to pay off student loan debt, there are huge drawbacks, warns Mark Kantrowitz, founder of Finaid.org. For one, you won't have that money and the substantial earnings that may accumulate when you retire. Instead, you'll have to start your retirement savings from scratch again. What's more, you'll be subject to a 10% penalty (assuming you're not yet 59 ½) and income taxes on the 401(k) withdrawal.

There are better other options, besides. If you have federal loans—such as an unsubsidized Stafford loan or Grad PLUS loan—take a look at the extended repayment option, which could cut your monthly payment by more than $200 by increasing the loan term to 25 years, says Kantrowitz.

Or, consider the income-based repayment, which would base your monthly payment on a percentage of your discretionary income. This may result in an even lower payment while you are underemployed.

There is also something called the economic hardship deferment that suspends your repayment obligation temporarily, though the interest will continue to build during the hiatus. If you think you'll get a full-time job soon, this option may work for you. Kantrowitz recommends that people who opt for a deferment continue to pay the interest on the loans during the suspension period to keep the balance from growing.

-- Walecia Konrad

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