Author Topic: Debt payoff vs 401k?  (Read 1205 times)

firstmatedavy

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Debt payoff vs 401k?
« on: June 03, 2020, 10:04:14 AM »
My spouse and I just reached our goal of rebuilding our emergency fund after my unemployment last summer. We've been able to save about 40% of our take-home pay for the past few months.

Our next goals are increasing our 401k contributions and paying off student loans. I did some googling on the subject and found an article suggesting paying off everything with more than 6% interest first before saving for retirement. This seems sensible to me, but I'd like to understand more about how to account for the tax advantage and employer match of retirement savings.

My employer matches 25% on the first 15%. My spouse's employer matches around 50% on the first 6% (I don't remember the details perfectly but he can look it up for me if necessary). I saved aggressively for a couple years before we were married, so I have more 401k/IRA savings than he does. I'm not sure if that matters or not.

We have around 25k in student loans at 6.55% interest, plus some at lower rates. Since that's not very much above expected market return (6% roughly), my intuition is that the tax advantage might make 401k savings about as good as debt payoff, and the match would make savings a better deal.

I'm leaning towards both of us putting 15% toward retirement and the rest toward student loans until all the 6.55% debt is paid off, which might be doable in under a year. (Home repair is a big part of our budget, and we can generally cash flow it but I haven't learned to predict it very well yet.)

Does this sound like the right approach? Is there anything I'm missing?

terran

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Re: Debt payoff vs 401k?
« Reply #1 on: June 03, 2020, 10:47:43 AM »
The recommended investment order sticky in the Investor Alley part of the forum recommends maxing out the 401(k) match and then paying off any debt ~5% or more above the current 10-year Treasury note yield (which is currently 0.762%) for a total of 5.762%.

Your match is interesting in that it's a relatively small match, but applied to a large amount of your contribution, so I could see that changing the math somewhat in favor of paying off debt faster, but it's still an instant 25% return, so probably worth taking unless it will take a very long time to pay off the debt.

I certainly wouldn't contribute more than the match before paying off 6.55% interest rate debt, so that would mean you should contribute 15% and your spouse should contribute 6%. You could look in to refinancing the student loans to a lower rate, but it sounds like you expect to be able to pay them off within a year, so I'd probably just do that.

Dicey

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Re: Debt payoff vs 401k?
« Reply #2 on: June 03, 2020, 11:02:35 AM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest. Every year you fail to invest in your retirement accounts is a failure on several levels. Here's a compound interest calculator. Use a pretend set of numbers and then run them through several timelines. You'll quickly see that the sooner you start, the fewer actual dollars you will have to earn with the sweat of your own brow. Once compound interesting begins to do the heavy lifting for you, it's amazing how it grows!

https://www.mathportal.org/calculators/financial-calculators/compound-interest-calculator.php

And definitely check out the Investment Order Sticky, as terran suggested.

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #3 on: June 03, 2020, 11:06:01 AM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'll definitely check out that sticky, thanks.

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #4 on: June 03, 2020, 11:11:29 AM »
I certainly wouldn't contribute more than the match before paying off 6.55% interest rate debt, so that would mean you should contribute 15% and your spouse should contribute 6%. You could look in to refinancing the student loans to a lower rate, but it sounds like you expect to be able to pay them off within a year, so I'd probably just do that.

I was hesitant to make our contributions too different (and I'm not fully sure why, I guess I'd feel weird about being "further ahead"? Not a gender roles thing, we're both guys), but bumping his down to pay off loans faster does make sense. I'll see what he thinks about it.

We thought about refinancing, but some of the other interest rates are under 5%, and now that we're in a lower cost of living situation we can probably pay down rapidly. They're also federal loans and I think we'd loose some protections by refinancing. So rapid payoff seems like the best approach.

Dicey

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Re: Debt payoff vs 401k?
« Reply #5 on: June 03, 2020, 11:14:40 AM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'll definitely check out that sticky, thanks.
It's relatively small amount. I would definitely take advantage of any SL abeyance that's available to you right now and consider a re-fi, even for 25k. I agree that you and your spouse should save the same amount, if possible.

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #6 on: June 03, 2020, 11:19:23 AM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'll definitely check out that sticky, thanks.
It's relatively small amount. I would definitely take advantage of any SL abeyance that's available to you right now and consider a re-fi, even for 25k. I agree that you and your spouse should save the same amount, if possible.

What's your reasoning for saving the same amount? I feel like we should but I'm not fully clear on why.

Dicey

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Re: Debt payoff vs 401k?
« Reply #7 on: June 03, 2020, 11:33:48 AM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'll definitely check out that sticky, thanks.
It's relatively small amount. I would definitely take advantage of any SL abeyance that's available to you right now and consider a re-fi, even for 25k. I agree that you and your spouse should save the same amount, if possible.

What's your reasoning for saving the same amount? I feel like we should but I'm not fully clear on why.
Because parity in a relationship is a good thing and hitting the max for two people helps both be stronger financially. Why do you think she should she save less of her income than you?

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #8 on: June 03, 2020, 11:59:05 AM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'll definitely check out that sticky, thanks.
It's relatively small amount. I would definitely take advantage of any SL abeyance that's available to you right now and consider a re-fi, even for 25k. I agree that you and your spouse should save the same amount, if possible.

What's your reasoning for saving the same amount? I feel like we should but I'm not fully clear on why.
Because parity in a relationship is a good thing and hitting the max for two people helps both be stronger financially. Why do you think she should she save less of her income than you?

We're both guys btw. His 401k match caps out at 6%, mine is a smaller match that goes til 15%. So raising my contribution from 6% to 15% results in more money than raising his by that amount. (We make about the same). So he'd get a bigger benefit from redirecting money from his savings to his student loans than I would.

Parity is a good way to describe the reason for both saving the same amount. Neither of us are going to hit the max until loans are paid off, I think.

terran

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Re: Debt payoff vs 401k?
« Reply #9 on: June 03, 2020, 12:02:14 PM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'm glad you spotted the error of logic in this statement yourself, so I don't have to say anything more.

mlipps

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Re: Debt payoff vs 401k?
« Reply #10 on: June 03, 2020, 12:31:55 PM »
The match is free money so you should always max that out before you pay off any debt besides MAYBE extremely high interest rate credit cards.

Beyond that, a couple things I'd consider:

1. What's your marginal federal tax rate? If you're both in the 10 or 12% federal bracket currently, I would be more inclined to pause the 401k contributions now than if you are in the higher tax brackets.
2. Are you currently able to max out your 401k contributions if you weren't paying the debt off? If you can already do that and expect to earn more throughout your career, you have to consider the "opportunity cost" of giving up some of your 401k space forever.
2a. If you can't currently max out your 401k contributions, do you expect to earn enough in the future to be able to do so? What's the rough time horizon?
3. Do either of you contribute to a Roth IRA? It may be more optimal to max this out before increasing your 401k contributions if you're in a low tax bracket.

Lastly, if you get to Jan of 2021 and you're confident you'll pay off the debt in that calendar year, I would definitely reduce your 401k contributions to the 6%/15% that maxes out the match, pay off the debt, then ratchet back up later in the year when the debt is paid off.

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #11 on: June 03, 2020, 02:13:06 PM »
Thanks, this is all good stuff.

We're in the 22% bracket. We won't be maxing our 401ks this year (because several months of savings went to rebuilding emergency funds after using them), but it might be doable next year if it weren't for the loans.

I think 6%/15% vs 15%/15% is going to come down to how my husband feels about it. I'm really not sure what the right thing to do is there.

mlipps

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Re: Debt payoff vs 401k?
« Reply #12 on: June 03, 2020, 03:04:23 PM »
I think the compounding interest difference between a 6.5% loan and 401k contributions is pretty likely to be a wash, which is why I'm focusing so much on the tax implications instead.

One thing that has helped me in the past is to calculate the amount of interest paid if I paid something off in 1, 2, or 3 years. Oftentimes, the difference in actual dollars isn't massive and it helps me realize that the right decision might just be whatever helps me sleep at night.

With that in mind...

If you're in the 22% tax bracket & can still pay off the loans in a year, I think both of you contributing 15% to your 401k's is a pretty reasonable place to draw the line. You might check to see how close that gets you to the top of the 12% bracket too--if you're close it could be worth throwing a little more in the 401k to stay there even if it delays paying off the loans by another month or two.

Additionally, up to $2500 of the student loan interest is tax deductible if your joint AGI is below $140k. So that makes the effective interest rate on the 6.55% loans only 5.764% in the 22% tax bracket. Again, use your 401k contributions to make sure you get below this cutoff.

One last thing to consider: did you get a partial stimulus check (between $1-$2400)? I did, so I am contributing more to my 401k this year than I had originally planned. The check was based on your 2018 or 2019 AGI, but if your 2020 AGI is lower you'll get an true up on your 2020 tax return. It effectively gives you a 5% credit for any reduction in income between $150,000 and $200,000 if you are married filing jointly without dependents.

Lots of things to consider & if you're not a tax nut like me it may sound a little overly complicated. Again, I think 15% each to your 401k and then pay off the loans is a totally reasonable line in the sand--just some other food for thought if you want to really optimize everything.

terran

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Re: Debt payoff vs 401k?
« Reply #13 on: June 03, 2020, 05:20:00 PM »
A married couple in the 22% bracket is earning at least $105k after tax deductible payroll deductions (like health insurance). Subtract FICA, two maxed out 401(k)s and $25k of student loan repayment and you're still left with $33k to pay taxes and pay for living expenses. Lots of couples on this forum live on similar income (my wife and I included). Just sayin'. Challenge assumptions about what's possible.

Dicey

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Re: Debt payoff vs 401k?
« Reply #14 on: June 03, 2020, 05:48:48 PM »
The problem with the first advice is that it completely ignores the incredible power of compounding interest.

Unfortunately the loan interest is compounding too. I think this makes getting the right order higher stakes, but doesn't change which order is best.

I'll definitely check out that sticky, thanks.
It's relatively small amount. I would definitely take advantage of any SL abeyance that's available to you right now and consider a re-fi, even for 25k. I agree that you and your spouse should save the same amount, if possible.

What's your reasoning for saving the same amount? I feel like we should but I'm not fully clear on why.
Because parity in a relationship is a good thing and hitting the max for two people helps both be stronger financially. Why do you think she should she save less of her income than you?

We're both guys btw. His 401k match caps out at 6%, mine is a smaller match that goes til 15%. So raising my contribution from 6% to 15% results in more money than raising his by that amount. (We make about the same). So he'd get a bigger benefit from redirecting money from his savings to his student loans than I would.

Parity is a good way to describe the reason for both saving the same amount. Neither of us are going to hit the max until loans are paid off, I think.
Whoops! Sorry for the incorrect assumption. FWIW, I hit the max at most one time in my not-high paying career and I still hit FIRE in a HCOLA no less. It's not the end of the world if you don't. Starting early and saving consistently are positive steps on the path to FIRE. In fact, I'd think saving to parity might be a healthier goal than hitting the max, at least at this stage.

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #15 on: June 03, 2020, 08:48:13 PM »
A married couple in the 22% bracket is earning at least $105k after tax deductible payroll deductions (like health insurance). Subtract FICA, two maxed out 401(k)s and $25k of student loan repayment and you're still left with $33k to pay taxes and pay for living expenses. Lots of couples on this forum live on similar income (my wife and I included). Just sayin'. Challenge assumptions about what's possible.

We're working on it. A lot of our expenses are related to home repairs, which should slow down once we can get ahead of the problems. I also find myself feeling afraid of having too much money tied up in tax advantaged accounts in case we discover something else major that must be fixed, so maybe we need a larger emergency/general stuff fund to feel safe having less month to month wiggle room.

We're also chipping away at smaller expenses. My husband just got interested in quitting aspartame, so the next project is replacing sodas with something homemade.
« Last Edit: June 04, 2020, 06:23:40 AM by firstmatedavy »

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #16 on: June 04, 2020, 06:54:32 AM »
We talked about it, here's an update on what we decided:

My husband feels strongly about putting in some significant retirement savings now that we've rebuilt the emergency fund, so we'll both put in 15%. We also discussed the math and figured that the tax implications will probably outweigh loan interest, but we're also tired of h loans, so 15% seems like a good balance.

The rest will go towards home repairs and extra student loan payments. We discovered that the expensive problem that a contractor said is probably fine is actually very not fine, but I'm still hopeful that it might only take a couple of months to pay for.
« Last Edit: June 04, 2020, 07:01:01 AM by firstmatedavy »

Dicey

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Re: Debt payoff vs 401k?
« Reply #17 on: June 04, 2020, 07:02:39 AM »
We talked about it, here's an update on what we decided:

My husband feels strongly about putting in some significant retirement savings now that we've rebuilt the emergency fund, so we'll both put in 15%. The rest will go towards home repairs and extra student loan payments.
I think that's a great idea! I'm also a fan of big, fat EFs, especially for homeowners. As for giving up fake sweeteners, this could be one way to do it frugally:

https://www.frugalwoods.com/2015/08/07/the-great-homemade-seltzer-discovery-of-2015/

simonsez

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Re: Debt payoff vs 401k?
« Reply #18 on: June 04, 2020, 09:20:31 AM »
The discussion has been pretty well-covered by now but I did want to add two quick points:

-If your student loans are federal there is no interest until September (including anything accruing/capitalizing) - this could tilt your decision to either pay more aggressively with the de facto principal-only payments, or it could swing you the other way to save more this summer while you have no loan obligations.
https://www.forbes.com/sites/zackfriedman/2020/03/25/student-loan-repayment-coronavirus/

-How are the fees in the 401k plans?  I hate fees and there are some atrocious and borderline predatory plans out there.  I have a friend who has a 5% load fee "for the privilege" of investing in funds with 1.5% as the lowest expense ratio.  My wife's 457 is garbage water as well and we only do 403b as a result (for the time being).  Knowing the fees associated isn't a bad thing to be aware of, even if it ultimately doesn't sway your decision one way or another - I find it can be a great motivator to either invest more in that vehicle, find a different vehicle with lower fees, or to prioritize debt repayment even more.

You're putting yourselves in a position to win no matter which strategy you go with, good luck!

Boll weevil

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Re: Debt payoff vs 401k?
« Reply #19 on: June 04, 2020, 09:54:36 AM »
From what I understand of the situation, I think the earned income during the marriage and resulting growth ought to be treated as one giant pot of money... there shouldnít be a yours and mine.

So for the duration of the marriage, half of what accrues in his account is yours and half of what accrues in your account is his.

An analogy would be a house. Even if one person is on the title and makes all the payments (say, because the other stays home to take care of the kids), both people should have equal equity for what accrues during the marriage. So if the house is purchased after the marriage, equity is evenly split. But letís say the marriage starts with one person having 30% equity and divorce occurs at the couple having 70% equity. Then the original owner should have 50% equity (original 30% + half of the 40% that accrued during the marriage) while the spouse should have 20% (the other half of the 40% that accrued during the marriage).

From a legal standpoint, I donít know if the law handles this automatically (I suspect it depends on state) or if you need some sort of written agreement (either pre- or post-nuptial).

But in my opinion, you should be using this concept as the starting point for whether you both should be saving 15% or you 15% and your husband 6%.


wonkette

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Re: Debt payoff vs 401k?
« Reply #20 on: June 04, 2020, 11:50:28 AM »
Echoing simonsez's point - are your federal loans deferred with no interest right now? I know not all of them are. If they are I think you should focus on cash savings to give you maximum flexibility, but plan on sending something towards the loans this fall. Hopefully no expensive surprises in your home repairs and you can make a sizable lump sum payment. Honestly I think they'll extend the interest free period because what politician wants to turn on interest and payments right before an election? So definitely don't refinance, but keep saving.

I'm also in a same sex couple. We make about the same now, but have made different amounts in the past and had different match situations. We focus (well, mostly me tbh because I have more interest) on an annual savings goal and percentage. Things being mostly equal now we put more into my wife's account because she's several years older. I agree it is good to strive for equal treatment but don't lose the forest for the trees.

firstmatedavy

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Re: Debt payoff vs 401k?
« Reply #21 on: June 05, 2020, 06:46:46 AM »
We talked about it, here's an update on what we decided:

My husband feels strongly about putting in some significant retirement savings now that we've rebuilt the emergency fund, so we'll both put in 15%. The rest will go towards home repairs and extra student loan payments.
I think that's a great idea! I'm also a fan of big, fat EFs, especially for homeowners. As for giving up fake sweeteners, this could be one way to do it frugally:

https://www.frugalwoods.com/2015/08/07/the-great-homemade-seltzer-discovery-of-2015/

Thanks!

The "Frugalwoods seltzer discovery" was my inspiration :) I'm going to try seltzer from the store mixed with Stevia and flavored baking extracts first, and if that goes well we'll shell out for a sodastream and tank.