401k vs student loans

[ScubaAZ]

What is the Mustachian perspective on contributing to your 401k before your student loans are paid off.  Brief background:  $100k in student loans at 6.8%.  Contributing the max to my 401k ($17,500, earning 4.5% so far this year).  Earn $120k a year, so in my head, the income tax savings (28%) on the $17,500 makes up for the additional interest on the student loan to make it a better investment than paying off the loans faster but paying more tax.  I have no idea where to start with the math on this though, and could be way off base.

[DavidR]

As a financial and tax professional I can confidently say that the answer to your question cannot be determined based on the information provided.  There are a number of variables here, such as your tax filing status, whether or not you can take a deduction for student loan interest, your liquidity position, your monthly payments and how much they put a strain on your finances, type of investments in the 401k and how likely the current yield will continue in the future etc.

The good news is that whichever way you go will be a plus, as long as you are doing one or the other you will be ahead of the game.  In fact, it may be that the choices are basically a wash financially and tax wise, and you should do what you think is best in your situation.

David Ricardo

[ScubaAZ]

I file as a single individual, cannot take a deduction for student loan interest (or really anything beside mortgage interest because of the high income), monthly payments and 401 k contribution are not a strain on my finances as is (though that $1500 a month could be going to pay down the loans vs. invested).  The 401k is invested in a target fund that is almost all equities.  So the yield depends on how well the stock market keeps doing I suppose. 

Thanks for responding... at least I wasn't missing some really simple mathematical formula that would produce a concrete answer :)  I tend to figure that either way, I'm  not spending that money on useless crap, so thats better than most.  I'd just like to maximize its potential to the extent possible.

[Mazzinator]

I'm no expert..but i'm getting that if you stop maxing out your 401k, then your net pay would only go up about $1050 a month..

If my math is correct, then you're
making (4.5%) about $780(gains) plus $500(tax savings) total $1270 on your $17.5k
vs
saving (6.8%) $850 of interest on your $12,600 payment.

I'm sure someone will correct me if i'm wrong ;-)

EDIT...to fix my math...

[DavidR]

I think your comment,

"either way, I'm  not spending that money on useless crap, " is exactly the right point here. 

Look with either choice you are increasing your personal net worth.  Paying down the student loans reduces your liabilities, investing the money in the 401k plan increases your assets. 

As a general rule the decision to invest in the 401K is the usually the better decision because

1.  The income inside the 401k compounds on a tax deferred basis.
2.  You have liquidity in that you can always borrow from the 401k plan if you need the funds

On the other side of the equation is that paying down the student loan provides for a guaranteed return equal to the interest rate on the loan, whereas investing in the market leaves you exposed to a drop in the value of stocks, and the more you have invested in stocks the larger the exposure.

I think you should go with the decision that makes you feel most comfortable based on your own risk tolerance.  And as we said, either way you are doing the right thing.

[foobar]

You are comparing pretax numbers (401k) with post tax ones (student loan).  You need to reduce the 401k ones by 0-39% depending on how rich you think you will be when the money comes out and what you think the tax laws will be in 30+ years.

The other thing to consider is that 401k is a use it or lose it type benefit. If you don't put in 17k in a given year, you can't go back and contribute. You can pay off student loans at anytime if you happen to get a big bonus one year. On the other hand 401(k) are not liquid. You can take loans from some plans but you run into problems if you get laid off.

Personally I would max out the 401(k),make sure you have a couple months of living expense, and put the half of your remaining free cash towards the loan and the other half in a post tax fund.

I'm no expert..but i'm getting that if you stop maxing out your 401k, then your net pay would only go up about $1050 a month..

If my math is correct, then you're
making (4.5%) about $780(gains) plus $500(tax savings) total $1270 on your $17.5k
vs
saving (6.8%) $850 of interest on your $12,600 payment.

I'm sure someone will correct me if i'm wrong ;-)

EDIT...to fix my math...

[Done by Forty]

Howdy, fellow Arizonan!

Given your marginal tax bracket, I would continue to max your 401k. 

[sdp]

Hello from up the hill in Flagstaff!
Do BOTH! There is a bigger picture here.  still having 100K in student loans and single makes me assume you are relatively young, which means you could easily be living in Phx on 20-25% of your income. Phoenix is an awesome place to live it up for free and there are so many young active people wanting to go play outdoors for free.
 I say max your 401(k) and ALSO aggressively attack the student loan if it is your only debt.  A single and active mustachian in Phoenix should be able to live comfortably on 20K a year with all the free city parks and surrounding mountains to enjoy for leisure, you don't have to spend much to still have a super social and healthy , active lifestyle.  Even with maxing out the 401(k) You should be able to pay off that student loan in 3-4 years and that would minimise the amount of interest you would pay over the life of the loan.  If you commit now to such an aggressive saving strategy, that will free up your time to address minimizing your expenses down to 20K a year.  then when your student loan is paid off you will have already established the mustachian lifestyle and found the social network in phx that will allow you to  continue your bad-ass super-speed road to financial independence.  When you are talking about just several years worth of allocation to either the student loan or 401(K) my guess is it won't matter too much in 15 years, any bad-ass aggressive saving strategy you implement right now will definitely trump any piddley tax savings.

[Done by Forty]

That's solid advice, sdp. 

[ScubaAZ]

Thanks, sdp.  That's my current plan.  I figured my savings rate right now (counting only debt principle as savings and interest as expense) is about 45%.  I can get it closer to 50%, I think, and then it will increase significantly as the interest payments become more principle and less interest.  Not counting the mortgage, we live off of about $15,000 a year (excluding debt interest) (family of 3, we just aren't married, hence the IRS counts me as single for tax purposes- social engineering through the tax code at its finest).  There are still  a few places to cut that back, including a somewhat anti-mustachian 2 car household with one 24 mile commute (round trip).  I'm giving myself the summer to get in shape, and then I'm going to give biking to work a go once its not 105 degrees outside.  Maybe by next summer I won't be such a pansy.

Using a debt repayment calculator I found on this lovely site, my student loans will be paid off in just under 4 years, even with putting the max in the 401k.  Assuming no bonuses or raises, which will immediately go toward the loans until they're gone.

[ScubaAZ]

You should be able to pay off that student loan in 3-4 years and that would minimise the amount of interest you would pay over the life of the loan. 

FWIW, paying it off in 4 years saves $82,000 in interest.  Isn't that crazy?!

[sdp]

Sweet!!  If you ever need to get out of that 105 degree heat, you can come stay in flagstaff with us for the weekend, mustachian style, bring your bikes and your water bottle!
Cheers,
Scott

[foobar]

How much in investment income does paying off the loan early cost you?  Somewhere between 70-100k is a pretty reasonable guess. A ~7% loan is right at the edge where you can go either way.

You should be able to pay off that student loan in 3-4 years and that would minimise the amount of interest you would pay over the life of the loan. 

FWIW, paying it off in 4 years saves $82,000 in interest.  Isn't that crazy?!

[Chowder]

I'm in almost an identical situation as the OP. In fact, I was thinking about starting a similar thread but now there's really no need.

$150k in loans @ 6.6%, making $70k with 25% bonus every 6 mos. I'm also currently almost maxing my 401k at $14k (Current YTD return 12.49%) and thinking about bumping it up that little extra. It wouldn't stress my finances but I feel better putting the money towards my loans.

I've currently got myself organized paying my student loans biweekly (as I'm paid) @ 142% of the minimum payment and the entirety of the bonus will be put towards my loans as I receive them. After all is said and done I leave myself $100/mo of income as wiggle room, yet I'm always looking for another way to put more towards my loans.