New raise. 401k or student loans

[Nicholas]

Hi all,

I was hoping people could offer me some insight about the best use for a new raise I got at work.  I will provide a little background. Before I started paying my loans I had built up a comfortable balance in an emergency account.  I currently have around 60k in student loan debt.  I started at 75k but in the past year I have been able to put 15k towards student loans. I have been putting enough into my 401k to receive my company match and dumping everything else into my loans. Starting with the highest interest rate and working my way down.  It would seem logical to take my raise (roughly 3k a year) and apply it towards student loans as well. This brings me to my question.

With my current tax burden I will give up 1/3 of my raise to uncle sam. This will leave me with about 2k to spend towards loans.  My alternative is to take all 3k of my raise and put it into my 401k. While the 401k will not likely outperform my loan rates, it is not exactly a fair comparison.  I can put 2k towards a 5% loan, or I can put 3k towards a 5% return in the market. If you include the fact that I do not have to pay taxes on the balance entered into my 401k, the rate of return on my 401k is 55% compared to the 5% saved on loans. Until my 401k is maxed out it would seem that by avoiding taxes I can improve my return rate.

I am curious as to other people's thoughts on this matter. I have a strong desire to shed my debt as fast as possible but also want to make sound, long term financial decisions. (Unlike the kind I made when I chose such an expensive school!) In my position which option would you suggest?

[Rebecca Stapler]

I suggest freeing yourself from the shackles of that SL debt. You will eventually pay taxes on that 401k when you withdraw it. Keep contributing to your employer's match, but use the rest to pay off those loans.

[tomsang]

Is there a tax benefit for the student loan interest?  If so what is the net interest cost of the student loan?  Compare that to expected return on investments during that time and you have your answer. With the 401k tax benefits, student loan tax benefits, and better liquidity with the 401k, I would probably go that route. Also what is your marginal tax bracket?  Either way as long as you are improving your net worth vs. spending then you are good to go.

Good luck on your quest for FI!!!

[GreenGuava]

What's the nominal interest rate on the student loans?

Is your income such that the student loan interest is deductible?

Are you getting your full 401(k) match already?

[CorpRaider]

I am facing the same question of whether to apply marginal dollars to tax advantaged savings accounts or reduce student loan debt and I believe I concur with your analysis.  Assuming no huge changes in the lowest marginal tax rate, it seems like you're getting a deduction at 33% and maybe paying 0% - 15%.

[Angelfishtitan]

I agree that the 401k will most likely be a (but is not a gauranteed!) better return on your money than the student loans.

However, since you claim your tax rate is 33% (and since a 401k only deducts federal income tax) that would imply you make at least $178K a year. Which then my question to you would be why can't you max out your 401K (which is $17.5K for your contributions) and pay down all of your student debt over the next few years? Not sure if you are overplaying your tax rate (or you are counting medicare/SS which you still would have to pay) or some other reason.

[trammatic]

However, since you claim your tax rate is 33% (and since a 401k only deducts federal income tax) that would imply you make at least $178K a year.

A lot of states use your federal AGI to calculate your state income tax burden, so the 401k would save that money as well.

[Nicholas]

$178k a year would certainly be nice! I did make some additions to my base tax rate.I included state tax, city tax, SS, and medicaid/medicare. All things considered I get to keep 2 of every 3 dollars I make which is where I got the 33% from. My base federal tax rate is 25%. I am squarely in the middle of that bracket at 61K + overtime which last year added about 3k or 4k to my salary. Having just graduated I was also unsure of how the deductions thing worked so I just put zero. Based on my tax return for last year I believe this leads me to overpaying on my taxes by quite a bit as well.

If I adjusted for all of this my tax would go down from 33% to maybe low 20s. While this would change the the final numbers I do not know that it changes the idea.

Based on this feedback I think I will take the extra money and apply it to student loans. The guaranteed return rate there beats speculation.  I think no debt might also be better for the goal of FI than a higher 401k that I cannot touch for quite a long time.

Thank you all for your feedback!

[CorpRaider]

I like your analysis op.  I am facing the same question.  If you earned nothing on your investments in excess of inflation and you are trading a 32% state and federal marginal rate for let's say a 12% state and federal blended rate in retirement, it seems like that beats a 6.25% return, for example, on the student loan. 

[RewardTraveler]

Just to clarify, 401(k) contributions don't impact your SS and Medicare taxes

[CorpRaider]

However, since you claim your tax rate is 33% (and since a 401k only deducts federal income tax) that would imply you make at least $178K a year.

A lot of states use your federal AGI to calculate your state income tax burden, so the 401k would save that money as well.

Yeah every state I've ever filed in starts with the federal AGI. and I've never seen one require adding back qualified retirement contributions.  That would seem pretty draconian.