Optimizing Loan Paydown and Pre-Tax Retirement Accounts

[Lars]

The idea:
For some of those paying down debts, it would be better to reduce their payments and put more into their pre-tax
retirement accounts beyond the employer match.

When it should be done:
Start with the maximum interest rate on a loan that you would not pay down. Lets say the rate is 3%.
Take your take marginal tax rate and subtract your predicted future marginal tax rate. Lets say 37% (Fed 25% + State 5% + Social 7%) and 20% (Fed 10% + State 5% + 5% future hike). So you gain 17% using a pretax account.
If you have a 6% loan you are paying off then you shouldn't payoff the loan faster than five years (17/(6-3)) until you are maxing out your pretax account or no longer paying a 25% marginal federal tax rate. 

I was wondering:
- Do you agree with the basic idea?
- What would your numbers be?

P.S. Before you ask, the maximum interest rate you select should take care of the expected future returns and discounting for future value. And I could have saved a couple thousand dollars if I'd thought of it a couple years earlier.

[grantmeaname]

What about mortgage and student loan interest, which are tax deductible? Do you calculate the interest rate after the tax benefits?

Those two loan types alone probably describe two-thirds of the debtors on the forums.

[Lars]

What about mortgage and student loan interest, which are tax deductible? Do you calculate the interest rate after the tax benefits?

Those two loan types alone probably describe two-thirds of the debtors on the forums.

Good point. At the price of additional complexity, it would be more accurate to adjust the loan rates. With the cap on student loan interested and the standard deduction, the benefit of the tax deduction expressed as a effective rate on the loan depends on how the loan is payed down over the whole year - that is a messy pain in the ass calculation so I am going to use approximations. The effect for mortgage rates will be fairly modest due to the subsidy of the standard deduction (if your total itemized deduction is 67% more than the standard deduction and your marginal federal rate is 25% that reduces the mortgage rate by 10%) The effect is a little stronger for student loans although obviously the cap on deductions sometimes reduces the drop in interest rate to less than the margin federal tax rate. Either way it would extend the optional repayment schedule even further.

Any thoughts on a good situation to use for a case study?