Author Topic: 401k contribution or Student debt  (Read 2554 times)

mcgb

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401k contribution or Student debt
« on: July 30, 2014, 01:45:37 PM »
Hi Everyone!
I was hoping to get some opinions on whether I should bother contributing to my 401k at all while paying down student debt? My employer does not offer a match but rather a pension contribution that is based on age and length of service. Until now I've been contributing about 100 dollars per weekly pay check to my 401k but I'm beginning to think I should suspend that and use the money to pay down the 25k I have remaining in student debt. About 16k of that is at  6.55% which is why I was leaning towards suspending the 401k contributions. Also, I really want to get rid of this debt just for the mental benefits alone!
Thanks!

Gone Fishing

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Re: 401k contribution or Student debt
« Reply #1 on: July 30, 2014, 01:57:19 PM »
Split the difference, put some towards the loan and keep funding the 401(k).  Make sure to save at least something in a taxable account for greater flexibility as well.

Cheddar Stacker

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Re: 401k contribution or Student debt
« Reply #2 on: July 30, 2014, 02:08:06 PM »
Read some of this:
http://forum.mrmoneymustache.com/ask-a-mustachian/let's-settle-this-with-a-vote-invest-or-payoff-debts/

The first post has some of the things you should consider in your analysis. There are many great responses arguing both ways, but it comes down to your specific situation. I would have to hear a lot more detail to give you my true opinion, but based on what you provided I would suspend 401k contributions temporarily in order to payoff the 6.55% loans. That's a nice high fixed rate of return on your money. Anything below 5-6% I would invest first. If you make a ton of money I would max your 401k first (anything in the 25% tax bracket).

Questions if you care to share:

Fixed or variable interest?
How high is the interest rate on the other $9K?
Is it tax deductible?
What is your tax bracket?

morjax

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Re: 401k contribution or Student debt
« Reply #3 on: July 30, 2014, 02:09:35 PM »
Quote
About 16k of that is at  6.55% which is why I was leaning towards suspending the 401k contributions. Also, I really want to get rid of this debt just for the mental benefits alone!

Typically you'd want to contribute up to your employers match (if they match dollar for dollar, it's a guaranteed immediate 50% ROI), but your pension will be increasing regardless of what you do. That muddies the waters a bit for the 6.55% loans.

I think that has to stem from your personality. Are you the type who would rather have a guaranteed 6.55% annualized return by paying off your student loans and have the weight of them off your shoulders, or have a chance at ~10% annualized returns by investing in the stock market. You ultimately have to do what lets you sleep at night, I think.

From a purely numbers aspect, the S&P 500 has a median 25 year annualized return of 12.98% (or ~10% after factoring in 3% average inflation). But for any individual year, returns have been as much as 37.58% or as low as -37.00%, including dividends. If you can stomach the swings, and if you have a very long time frame, your profits would approach 10% after inflation if you assume the market continues to behave as it has (which nobody will guarantee it does; every prospectus says "past performance does not guarantee future results").

Guaranteed 6.55% now? Maybe an average of 10% later with +/-35% along the way? You judge what feels right for you. There is something to be said for making the choice that energizes you (being debt-free? Getting a higher return?) in order to keep your enthusiasm and tenacity up.

Good luck!

P.S. The above applies to your 6.55% loans. For these the return is close-ish versus the market, enough so to make an argument either way. For your student loans that are (presumably) at a lower interest rate, you likely want to pay teh minimum and invest the difference (or put that towards your other loans, again, your call).

edit: Cheddar Stacker raises good points as well that I neglected for simplicity (*self-facepunch* for my laziness!!)

Numbers Man

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Re: 401k contribution or Student debt
« Reply #4 on: July 30, 2014, 02:27:36 PM »
Why is everyone in such a hurry to pay off student loans? Maybe this low interest rate environment we are in is messing with everyone. A contractual student loan payment is not going to go away until the loan is paid off. Sure, You're reducing the principal, but basically, the interest is being paid during the early years of the loan. So why not take advantage of the compounding of you 401(k) balance and continue to feed it? You are way ahead of the game with your savings into a 401(k) plan, especially since I'm guessing you're a few years south of 30 years old. Keep the habit of contributing to the 401(k).

mginwa

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Re: 401k contribution or Student debt
« Reply #5 on: July 30, 2014, 05:15:15 PM »
You should do both.

First, you should definitely be paying all interest on the loans off in full each month. If you make less than $80k/year as a single tax filer in the US, you will be able to deduct some or all of that interest on your taxes, which is a nice benefit while you're paying down your student loans. That is certainly not a reason to keep paying interest, but if you can take that deduction and roll it back into paying the loans off, all the better. If you are eligible for it, that tax deduction reduces your effective interest rate by your highest tax bracket, so if you're in the 25% bracket, your effective interest rate is 6.55%*.75=4.9%

After that, if you earn enough to pay taxes, the math is in favor of the 401k contribution. Your ROI in the year you make the contribution is equal to your highest tax bracket, again let's say 25%, plus whatever gains you have. You can count on an investment in a S&P Index fund to make 7% on average every year. 25%+ is bigger than 6.55% (or the effective 4.9% if applicable), so make the 401k contributions. Mathematically, the most optimal thing to do is first to pay all interest, second to max out your 401k, and third to aggressively pay down the student loans, but $17,500/year is a lot of money to put into your 401k if you don't have a large income and you have loans hanging over your head.

I'd suggest splitting the money in whatever proportion makes you feel the most comfortable. If you aren't going to go on what is purely mathematically optimal, then go with whatever makes you feel the best about your financial situation. Once you are done with the loans, though, refocus on the 401k and other savings.

Good luck!