Author Topic: FIRE FAQ: Should I Pay Off Debt or Invest?  (Read 4168 times)

ranchingretirement

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FIRE FAQ: Should I Pay Off Debt or Invest?
« on: September 23, 2016, 07:36:27 PM »
Hi everyone!

I've got a twist on the age-old question "Should I Pay Off Debt or Invest?", that I've never heard anyone address before:

What are the considerations of your income tax bracket on the determination to pay off debt or invest first? Am I trying to compare apples and oranges here (post vs. pre-tax), or is this a valid consideration?

Just to put some hard numbers to my personal situation:

Basic Financial Info
- Annual joint income of approximately $180k (my wife and I)
- We have approximately $20k in CC debt that I have been able to continually roll over to 0% interest using 2-3% balance transfer offers
- We also have approximately $20k in personal loan debt at 7%
- We have no other outstanding debt
- We live in California, and fall in the 25% tax bracket based on our current pre-tax investment strategy

Investment Availability
- Access to a 401(k), with 5% employer matching
- Access to a 457(b)
- Access to a 403(b)
- Access to an HSA

Current Approach
We are actively investing the maximum into both the HSA ($6.65k) and the 457(b) ($18k) due to the favorable tax implications, along with 5% into the 401(k) to receive the employer matching. This approach, along with our current monthly spending, will allow us to fully pay off all debts in approximately 2 years.

Questions
- Am I wrong in thinking that every dollar invested into any of the tax-advantaged accounts is automatically receiving a guaranteed 25% return?
- Should I be thinking about paying off the debt more quickly (6-9 months) instead of taking advantage of the tax-advantaged investment accounts?

I haven't seen this twist to the question (i.e. tax-advantaged accounts vs. debt payoff) answered very clearly before. Hopefully the Mustachian community has some thoughts?

MDM

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #1 on: September 23, 2016, 09:02:58 PM »
Questions
- Am I wrong in thinking that every dollar invested into any of the tax-advantaged accounts is automatically receiving a guaranteed 25% return?
Yes, the "automatically" part is incorrect.

E.g., if you merely put the money into a money market paying ~0%, then withdraw it when you are paying the same marginal rate you saved for the initial investment, you have gained nothing at all.

Quote
- Should I be thinking about paying off the debt more quickly (6-9 months) instead of taking advantage of the tax-advantaged investment accounts?
I haven't seen this twist to the question (i.e. tax-advantaged accounts vs. debt payoff) answered very clearly before. Hopefully the Mustachian community has some thoughts?

Here is the "usual advice", current as of the posting date.  See the 'Investment Order' tab in the case study spreadsheet for the latest version.   
"Max..." means "contribute up to the maximum allowed for..., subject to your ability to pay day-to-day expenses."   
   
It is up to you whether to consider "saving for a house down payment" as a "day to day expense", vs. lumping the down payment savings in with "taxable investments" at the end.   
If you are renting, you may not be throwing away as much on rent as you might think.  See   
   http://jlcollinsnh.com/2012/02/23/rent-v-owning-your-home-opportunity-cost-and-running-some-numbers/ for some thoughts.
   
In the lists below, thinking "first your 457 (if you have one), then your 401k and/or 403b" wherever "401k" appears is likely correct -   
   unless your 457 fund options are significantly worse than those in the 401k/403b -
   due to penalty-free access to 457 funds at retirement, even if younger than 59 1/2.
   
Differences of a few tenths of a percent are not important when applicable for only a few years (in other words, these are guidelines not rules).   
   
Current 10-year Treasury note yield is ~2%.  See   
   http://quotes.wsj.com/bond/BX/TMUBMUSD10Y
   
WHAT   
0. Establish an emergency fund to your satisfaction   
1. Contribute to 401k up to any company match   
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.   
3. Max HSA    
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level   
5. Max 401k (if 401k fees are lower than available in an IRA, or if you need the 401k deduction to be eligible for a tIRA, swap #4 and #5)   
6. Fund mega backdoor Roth if applicable   
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.   
8. Invest in a taxable account with any extra.   
   
WHY   
0. Give yourself at least enough buffer to avoid worries about bouncing checks   
1. Company match rates are likely the highest percent return you can get on your money   
2. When the guaranteed return is this high, take it.   
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.   
4. Rule of thumb: traditional if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between (or see   
   http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/
   if you want even more details on that topic).  See also
   https://www.bogleheads.org/forum/viewtopic.php?f=2&t=182081,
   http://forum.mrmoneymustache.com/ask-a-mustachian/case-study-overwhelming-student-loan-debt-how-would-you-get-started/msg868845/#msg868845
   and other posts in that thread about exceptions to the rule.
5. See #4 for choice of traditional or Roth for 401k   
6. Applicability depends on the rules for the specific 401k   
7. Again, take the risk-free return if high enough   
8. Because earnings, even if taxed, are beneficial   
   
The emergency fund is your "no risk" money.  You might consider one of these online banks:   
   http://www.magnifymoney.com/blog/earning-interest/best-online-savings-accounts275921001
      
If your 401k options are poor (i.e., high fund fees) you can check   
   http://forum.mrmoneymustache.com/investor-alley/to-401k-or-not-to-401k-that-is-the-question-43459/
for some thoughts on "how high is too high?"   
   
Priorities above apply when income is primarily through W-2 earnings.  For those running their own businesses (e.g., rental property owner, small business owner, etc.),   
   putting money into that business might come somewhere before, in parallel with, or after step 5.

ranchingretirement

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #2 on: September 23, 2016, 09:29:48 PM »
Thank you for the great response! Seems so simple, not sure why I was having trouble with the implications of the tax rate...so if I assume that my marginal tax rate post FI would be 15% vs 25%, the "return" on this money would be 10%, not much higher than the guaranteed 7% return I would get by paying off the personal loan. Appreciate the help, and looks like I need to make a few adjustments to our financial priorities over the next 6 months to knock out that debt prior to investing as heavily as we have been over the last year or so.

MDM

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #3 on: September 23, 2016, 10:01:02 PM »
... looks like I need to make a few adjustments to our financial priorities over the next 6 months to knock out that debt prior to investing as heavily as we have been over the last year or so.

As whole books have been written on investment strategies, it's tough to cover everything in one forum post.  One thing to consider in your situation is that 401k, etc. contribution limits reset every 1-Jan but extra loan payments aren't so restricted.  In other words, it's probably not worth shorting your 401k/403b/457 contribution for a given year just to pay off a loan in December instead of January.

Goldielocks

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #4 on: September 23, 2016, 11:09:57 PM »
Thank you for the great response! Seems so simple, not sure why I was having trouble with the implications of the tax rate...so if I assume that my marginal tax rate post FI would be 15% vs 25%, the "return" on this money would be 10%, not much higher than the guaranteed 7% return I would get by paying off the personal loan. Appreciate the help, and looks like I need to make a few adjustments to our financial priorities over the next 6 months to knock out that debt prior to investing as heavily as we have been over the last year or so.

Not quite right.

the 10% is a ONE TIME 10%, not a yearly, on-going return.   your on-going return is just your investment return, over those years, on top of the 10%.

BUT
the 7% is 7% the first year, then another 8%, then 9%, etc.    After 10 years, it is (1.07)^10  percent increase   or a 96% "return"....

RobFIRE

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #5 on: September 24, 2016, 03:30:47 AM »
Simplifying OP's scenario / approximating from the info provided:
* 20k debt at 7%
* 20k debt at 3% (assume annual balance transfer cost)
* currently paying down debt at $1500 a month
* max contributions to retirement accounts, which includes 25% tax saving
* no other money available to pay down debt

Leads to question: debt could be paid down faster by reducing retirement account contributions, but does this save money overall?

So it should be an evaluation of debt interest versus tax savings. The tax saving is 25% one off. The debt is a sum of 40k at ~5% a year, so over two years interest would be at most 1.05*1.05 i.e. 10.25% or $4100. But as you would gradually pay it down actual total interest paid would be less. To reduce retirement account investments by $40k net would be $53,333 gross with 25% tax, so loss of $13k in investment capital. Some of that extra investment money will be taxed when you eventually take it out, so allowing something for that it's still $10k reduction. So on the face of it, it would cost you $6k or so to pay off the debt early. However, the peace of mind from being debt free is worth something.

However, looking at the bigger picture, if you have combined gross income of $180k and each do $6.5k+$18k + 5% investments, then pay 25% tax on the rest (which presumably you won't as some of it will be taxed at a lower rate), then that leaves half of it, $90k, so $7500 a month as take home. If you put $1500 for debt payment, the rest of your life costs $6000 a month. Is there no scope to reduce that portion to pay off the 7% debt a bit faster?

ranchingretirement

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #6 on: September 24, 2016, 07:41:02 AM »
RobFIRE, thanks for the great response! This is what I was trying to get at.

clarkfan1979

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #7 on: September 24, 2016, 10:38:16 AM »
Thank you for the great response! Seems so simple, not sure why I was having trouble with the implications of the tax rate...so if I assume that my marginal tax rate post FI would be 15% vs 25%, the "return" on this money would be 10%, not much higher than the guaranteed 7% return I would get by paying off the personal loan. Appreciate the help, and looks like I need to make a few adjustments to our financial priorities over the next 6 months to knock out that debt prior to investing as heavily as we have been over the last year or so.


+1

EnjoyIt

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Re: FIRE FAQ: Should I Pay Off Debt or Invest?
« Reply #8 on: September 24, 2016, 11:16:17 AM »

However, looking at the bigger picture, if you have combined gross income of $180k and each do $6.5k+$18k + 5% investments, then pay 25% tax on the rest (which presumably you won't as some of it will be taxed at a lower rate), then that leaves half of it, $90k, so $7500 a month as take home. If you put $1500 for debt payment, the rest of your life costs $6000 a month. Is there no scope to reduce that portion to pay off the 7% debt a bit faster?

Right here is your answer.  I am a big fan of maximizing retirement accounts, but I am also a big fan of paying down debt that is >4%.  In my opinion your 7% loan has got to go but I am sure it can be done with just a little change in lifestyle.

Look at what you are spending on and try and decrease it by as much as possible.  Stop eating out, don't buy that latest cell phone, get rid of cable, figure out how to spend less on groceries, no new clothes, no new electronics, bring lunch to work, minimize alcohol intake, for the next year don't travel, and look around your house for ways to sell some of the crap you have accumulated over the years.  I am positive before you know it the 7% loan will be gone

BTW, just because you are paying 2-3% to keep your credit card debt down, you are also losing out on other credit card opportunities such as this new chase sapphire reserve card, or the chase ink plus card both of which can give you over $2k worth of free travel.

What about the cashflow you are wasting by having to pay credit card debt and personal loan debt?

Basically your consumer debt is holding you back while you are comfortably spending $6k a month on your fancy pants lifestyle.  If you put some motivation on this you can have that debt gone in under a year.