Author Topic: 401 or debt?  (Read 4443 times)

LawDebtCrusher

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401 or debt?
« on: April 21, 2015, 11:49:49 AM »
I'm new here and I'm sure this topic comes up fairly frequently, but I'm not the best at searches and perhaps my situation would change the advise. When I get the time I may put up a full case study. I'm sure I'd be ripped to shreds about my expenditures.

Anyways, here is the deal- My partner and I had over $300k in student loans as of 2.5 years ago. We are now down to $115k. We have no other debt. I'm pleased with our loan repayment progress so far, but now that we have a baby in daycare and I'm working reduced hours (lower paycheck), we aren't going to be able to put nearly as much money towards our debt as we were before. Previously we paid about 50% of our take-home pay towards debt repayment. Daycare costs 25% of our take home pay. We have been maxing out our 401ks each year and combined have about $100k in them. We have an emergency fund/house down payment saved as we plan to buy a house in about 1-2 years. We have no other savings/investments.

Up until now, I've felt that maxing out the 401k made sense because we will be setting ourselves up for the future and we have high incomes so we could 1) lower our taxes and 2) still make major progress on the loan front. Now, I'm not so sure what to do. I'm working on various ways to reduce our expenditures to help increase the amount to pay towards debt and reducing 401k contributions is one of the things I'm considering.

BlueLesPaul

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Re: 401 or debt?
« Reply #1 on: April 21, 2015, 12:06:00 PM »
First off.  Great job paying off that much debt in 2.5 years.  That is truly impressive.

A couple of quick questions?

-Do either of your employers offer a 401k match?
-What are the interest rate(s) of your student loans?

I would contribute at least up to the match.  After that, see what expenditures you cut out would be best.  Aftter reviewing expenditures, whether to pay off the loans or contribute to the 401K depends on you tax situation and the rates of your student loans.  Certain tax credits (child tax credit and dependent care tax credit) phase out or are reduced as income increase and increasing your 401K may make contributions worth it.  My assumption is that your gross income is far too high to get you close to the phase outs, but it is something to consider.  If your loan are 2% or less, I would invest, 6% or more I would pay off the loan and anywhere in between would be up to you.

Good luck!

LawDebtCrusher

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Re: 401 or debt?
« Reply #2 on: April 21, 2015, 12:16:08 PM »
We do not receive 401k matching

Half the debt is at 6.55% and half is at 7.55%

We do not qualify for any deductions/credits with phase-outs (child, student loan interest) because of our income.

pksr

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Re: 401 or debt?
« Reply #3 on: April 21, 2015, 12:30:06 PM »
With no match, I think you should turn on the Rocky music and pay off the debt asap. Your student loan debt (since you seem to be above the threshold for any tax benefit) is after-tax, so, depending on your tax rate, could be the equivalent of a 9 or 10% pre-tax risk-free return. A 401K is one of the greatest inventions ever, but if I were you I'd kill the student debt first.

An alternative view is that you are making great money and there are indeed limits on 401K contributions, so you'd be better off maxing out your 401K each year so you don't "miss" any of the annual $18K chunks available to you. I see that logic, but I think the 401K is your second-best investment option right now, with paying off your debt as #1 (full disclosure - my sense of market timing, which is anathema to some here, does influence that thinking).

Cheddar Stacker

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Re: 401 or debt?
« Reply #4 on: April 21, 2015, 12:40:16 PM »
Can you refi those loans? A lot of people around here talk about using SoFi for that. There are plenty of referral links floating around. I'd look into that first unless you are absolutely sure you can pay them off within a year, but even that would be $5-7K interest and you might be able to cut that in half with a refi.

If you are planning to FIRE, then the tax savings by maxing the 401K is too big to pass up. You are likely in the 28-35% tax bracket. If you plan to retire in 10 years and can live off $100k/year, your tax rate will be < 10%, maybe < 5% if you plan accordingly.

That's a possible 30% tax savings, and on $36K that's $10,800. This doesn't even count the potential investment return, although that might be less than the interest savings by paying down the debt.

If you plan to work for 25 years, or can't live on $100K, it's a much smaller tax savings so adjust accordingly. If I'm you though, I refi that SL debt, keep on maxing the 401k's, and use the rest for debt killing.

seattlecyclone

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Re: 401 or debt?
« Reply #5 on: April 21, 2015, 12:44:07 PM »
We do not qualify for any deductions/credits with phase-outs (child, student loan interest) because of our income.

If you did max out your 401(k), would that bring your income down enough to be eligible for the child tax credit or student loan interest deduction, or are you way above the phase-out range? The answer should help inform your decision. If those things are completely out of reach for you, I agree that debt repayment makes sense, and it might make sense even if those tax credits could come into play.

The amount of money you have available for saving will also make a difference. If you have something like $60k or more available to save, I might suggest maxing out the 401(k) and putting the rest toward the debt, since the debt will be gone within a couple of years regardless, and you can't go back in time to make 401(k) contributions for this year after the fact.

trammatic

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Re: 401 or debt?
« Reply #6 on: April 21, 2015, 12:51:31 PM »
We have an emergency fund/house down payment saved as we plan to buy a house in about 1-2 years.

Provided that you both have high-paying jobs, I'd consider reducing the EF significantly short-term.  If one of you happened to lose a job, you'd still have the other's income to pay bills and could temporarily cut day care.  I'd strongly advise against entering into home ownership with significant SL payments on the cash flow.

Sid Hoffman

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Re: 401 or debt?
« Reply #7 on: April 21, 2015, 01:17:32 PM »
We do not receive 401k matching

Half the debt is at 6.55% and half is at 7.55%

If your income is in the 25% bracket (as I suspect it is, based on your comment about being too high income to qualify for tax credits) then look at it this way:

401k money = avoid 25% federal income tax, maybe even 35% total income tax if you live in a high tax state
Debt repayment = avoid 7% interest

Looks to me like you'll make 4x the return by putting the money in your 401k, not to mention that once it's invested in the 401k you start earning compounding returns year after year.  I don't even see this as a competition; the 401k wins by a mile in your tax bracket.

pksr

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Re: 401 or debt?
« Reply #8 on: April 21, 2015, 01:31:09 PM »
We do not receive 401k matching

Half the debt is at 6.55% and half is at 7.55%

If your income is in the 25% bracket (as I suspect it is, based on your comment about being too high income to qualify for tax credits) then look at it this way:

401k money = avoid 25% federal income tax, maybe even 35% total income tax if you live in a high tax state
Debt repayment = avoid 7% interest

Looks to me like you'll make 4x the return by putting the money in your 401k, not to mention that once it's invested in the 401k you start earning compounding returns year after year.  I don't even see this as a competition; the 401k wins by a mile in your tax bracket.

I think the math is a little more complicated than that. The expected return on the 401K and the benefit of delaying (or, as noted above, removing altogether if a FIRE candidate who can do the Roth shuffle) the taxes due on those earnings need to be compared to cost of the debt. It's not a comparison of 25%, which is a marginal tax rate, to the 7%.

LawDebtCrusher

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Re: 401 or debt?
« Reply #9 on: April 21, 2015, 02:24:02 PM »
Thank you all for your comments. There is a lot to think about.

Some comments in reply:

I will look at refi. I think I'd qualify under SoFi

Our taxes are quite high. In addition to federal, we have state and NYC income taxes. Even with full 401k contributions we don't qualify for any breaks. I don't actually mind taxes, I think they are our social responsibility, but when you're paying half your income to student loans and over $1000/month in interest (in the beginning) its annoying that none of that counts. I don't think of myself as wealthy since I have so much student debt.

I've considered reducing our EF/house fund. With a baby and living in NYC, if one of us lost our job, rent + debt would eat up almost entirely the other's income. We also do not plan to stay in these jobs for more than another year. They are extremely demanding. It's highly unlikely our salaries will be this high for some time (if ever). But we also will move to a lower cost of living area.

I'm not planning on early retirement yet. First, I'm focusing on getting out of debt, with an eye to the future. Once we're out of debt, then we can really think about our priorities going forward.

Depending on how much we can put towards loans in the next year, by the time we are wanting to buy a house, the debt will be minimal. I'm sick of renting and seeing allll that money go down the drain. We live in a one-bedroom with a baby so I'm also looking forward to having some space. Right now, we are prioritizing debt over the convenience of more space.

JLee

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Re: 401 or debt?
« Reply #10 on: April 21, 2015, 02:35:13 PM »
Thank you all for your comments. There is a lot to think about.

Some comments in reply:

I will look at refi. I think I'd qualify under SoFi

Our taxes are quite high. In addition to federal, we have state and NYC income taxes. Even with full 401k contributions we don't qualify for any breaks. I don't actually mind taxes, I think they are our social responsibility, but when you're paying half your income to student loans and over $1000/month in interest (in the beginning) its annoying that none of that counts. I don't think of myself as wealthy since I have so much student debt.

I've considered reducing our EF/house fund. With a baby and living in NYC, if one of us lost our job, rent + debt would eat up almost entirely the other's income. We also do not plan to stay in these jobs for more than another year. They are extremely demanding. It's highly unlikely our salaries will be this high for some time (if ever). But we also will move to a lower cost of living area.

I'm not planning on early retirement yet. First, I'm focusing on getting out of debt, with an eye to the future. Once we're out of debt, then we can really think about our priorities going forward.

Depending on how much we can put towards loans in the next year, by the time we are wanting to buy a house, the debt will be minimal. I'm sick of renting and seeing allll that money go down the drain. We live in a one-bedroom with a baby so I'm also looking forward to having some space. Right now, we are prioritizing debt over the convenience of more space.
A lot of money goes down the drain when you buy a house, too. Homeowners' insurance, property taxes, etc. I understand that rent can be frustrating, but it certainly has its purpose!

MDM

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Re: 401 or debt?
« Reply #11 on: April 21, 2015, 03:29:12 PM »
I think the math is a little more complicated than that. The expected return on the 401K and the benefit of delaying (or, as noted above, removing altogether if a FIRE candidate who can do the Roth shuffle) the taxes due on those earnings need to be compared to cost of the debt. It's not a comparison of 25%, which is a marginal tax rate, to the 7%.

One (among many) ways to look at it - assume:
1) The loan will be paid off in 5 years.  $115K at 7.55% over 5 years = $2,307.10/mo, so assume that after-tax cash flow is available.
2) A $36K lump sum is available, and can either go into 401k funds or (after paying tax) pre-paying loan principal.
3) Income is too high to use the SL interest deduction on federal taxes
4) Investments earn 5%
5) Marginal tax bracket is 28%

If the $36K goes into the 401k, after 60 months
  - the mortgage is paid
  - the 401k funds have grown to $45,946.14

If the $36K goes toward the loan principal,
  - $10,080 is paid in taxes, and $25,920 pays principal
  - the loan is paid after 45 months, with a final month payment of $1,074.51, leaving $1,232.59 for investment that month
  - for the remaining 15 months, the $2,307.10 is invested in a taxable account
After 60 months,
  - the mortgage is paid
  - the taxable account has grown to $36,946.23 with a basis of $35,839.09

Then the question becomes, "which is worth more: $45,946 in a 401k or $36,946 in taxable?"  That answer isn't straightforward, because it depends not only on the tax rates but the number of years before the money is withdrawn.  E.g., if
  P1, t1 = the 401k principal and tax rate
  P2, t2 = the taxable principal and tax rate
we have for after tax values:
  401k =     P1 * (1+i)^n * (1-t1)
  taxable = P2 * (1+i)^n * (1-t2) + t2*P2 (because the tax is due not on the entire amount but only the amount above the basis)

Of course, if t2=0 then the ratio 401k/taxable reduces to P1/P2 * (1-t1).

With P1 = 45,946 and P2=36,946 the options are equal (with t2=0) when t1 = 19.6%.

So - assuming all the above assumptions hold - if the expected overall tax rate on the 401k withdrawals in retirement is <19.6%, put the money in the 401k.  Otherwise prepay the loan.

If, however, the capital gains tax on the taxable withdrawals is 15% instead of zero, the breakeven (i.e., above which the loan prepayment is better) 401k withdrawal taxes become
  for 10 years, 24.2%
  for 20 years, 27.1%
  for 30 years, 28.9%

If reality differs from the assumptions, the conclusion may also change.  E.g., if the investment returns are 8% instead of 5% the breakeven 401k withdrawal tax rates are
  For t2=0,         28.9%
  For t2=15%,
    for 10 years, 34.6%
    for 20 years, 37.2%
    for 30 years, 38.5%

If the current marginal rate is higher than 28%, that will increase all the breakeven rates calculated above (i.e., make it more likely the 401k is the better option).

ETA one other assumption: no taxes on the taxable account until withdrawn (e.g., all increases due to capital gains alone).  Imposing any annual taxes makes the 401k that much better.
« Last Edit: April 21, 2015, 03:32:34 PM by MDM »

BlueLesPaul

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Re: 401 or debt?
« Reply #12 on: April 21, 2015, 04:17:40 PM »
It is important to note the tax savings of investing in a 401K, espcially for high earners, but all of these assumptions on a 7% return is forgetting the timeframe. 

Base on the fact that OP was able to reduce the principle of student debt from 300k to 115k in 2.5 years, OP was able to put an average of 74K toward principal per year.  At this rate, they could pay off the student loans in about 1.5 years (making the assumption that there wasn't a lump sum payment that cannot be anticipated in the next 1.5 years or so).  It is true that 401K could have gains, but it is also true that during that timeframe the 401K could lose significant value, depending on how it is invested.  The student loan payment is a guaranteed ROR. 

I would agree to that you should look into refinance of the loan(s).  The lower you can get the rate, the less it would make sense to expedite the loan payoff.

MDM

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Re: 401 or debt?
« Reply #13 on: April 21, 2015, 04:31:23 PM »
...all of these assumptions on a 7% return is forgetting the timeframe. 
...  At this rate, they could pay off the student loans in about 1.5 years
True, although the OP did say "we aren't going to be able to put nearly as much money towards our debt as we were before."

Quote
It is true that 401K could have gains, but it is also true that during that timeframe the 401K could lose significant value, depending on how it is invested.  The student loan payment is a guaranteed ROR. 
Absolutely true.  One can always take the bird in hand, which may or may not be better than the number one can glean from the bush.

LawDebtCrusher

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Re: 401 or debt?
« Reply #14 on: April 22, 2015, 08:04:57 AM »
Wow! Thank you all so much for your comments. We have been able to put about $6k towards loans every month, plus all bonuses, tax refunds, etc. However, now our son will be in daycare and in NYC full-time infant daycare is almost $3k/month. There are obviously other expenses with a baby and I have a reduced income now. I'm working on cutting back in all areas and I think we will still be able to put $3500/month towards loans plus any bonuses, tax refunds, or any other income we may stumble upon.

I think for now I will continue to max the 401ks and see if I can get refinancing on the debt.

Thank you again for all of your help. I really appreciate the time people took to do the math for me and lay out some other considerations.