Should I max out my 401(k) contributions or make principal payments on student loan debt?
I am 25 years old and currently putting about $6,000 per year into my 401(k). Between my wife and I, any extra income goes towards principal payments on $90,000 of student loans. Should I max out my 401(k) contributions for a certain number of years to boost the size of my 401(k) while I am still young instead of putting it toward the extra principal payments on the student loans? Or should I continue to put the extra income towards the student loan principal and keep my 401(k) contributions how they currently are?
Congratulations on a great start to your retirement! Paying off your loan has a lot of benefits. But does your plan offer a match on your contributions? At $6K you are likely getting any match, but make sure you understand the specifics going forward as you get raises and promotions. There are various formulas, but any match is essentially free money. Maximize your match first. Make sure you are considering any retirement plans your wife has access to. Consider your benefits collectively as well as independently.
Here are some other important reasons and related concepts that dig into your question, that may improve your financial health and retirement planning.
As your debt is paid off, mentally partition and budget those payment amounts towards retirement savings or long-term purchases on things such as a down payment on a home.
Paying off loans improves your debt to income ratio which can improve your credit scores and ability to get better home and auto loans and better rates on credit cards.
Paying off debt is like earning the loan rate with zero risk. For example, take a 4% loan making only minimum payments, but there is money for savings or larger payments. You could place the extra money into a CD, but it will be practically impossible to get a risk-free return of 4% or higher. Therefore, you earn less than the loan is charging in interest. If you place the extra money into the markets or other risky assets, you may make a higher total return or a lower return than 4%. These higher risks are hard to justify versus Zero Risk because you could have equivalently earned 4%. Your net risky assets earnings after interest accruing in the loan are only the return over 4%.
Make sure you have an emergency reserve. Early withdrawals on your 401K face income taxes and a 10% penalty. There are cases where you can take a loan from your 401K but is rarely wise to do so. 3 to 6 months of your monthly spending needs should be in reserves. Explore things like CD’s if you don’t like the cash in your checking or savings account to earn a bit more interest.
Does your 401K plan have a Roth option? If your tax bracket is relatively low, consider some or all of your contributions into a Roth. You lose the current tax reduction, but don’t pay taxes on future withdrawals. (Employer matches are still regular 401K.) Working with a Financial Planner who does ongoing tax analysis can be of great benefit because your tax efficiencies can change over time between saving on taxes now or later. A Comprehensive Financial Plan has a lot of other benefits as well.
Hope this helps you build a better future! Happy to answer any further questions.
David Nash, CFA,CFP®
I'd recommend only contributing enough to your 401k to get the company match. Any additional funds should be dedicated to debt elimination. Eliminating the student loans will increase your monthly net cash flow and allow you to save a serious amount of money each month!
Thanks for the question and best of luck!
Balancing your cash flow and progress towards saving for retirement AND paying off student loan debt is key. First, you'll want to ensure you're at a minimum getting your employer's match in the 401(k) if they offer one. Second, depending on what the interest rates are on your student loans, you'll either want to contribute more towards it's paydown or put more towards your 401(k).
One way to think of paying off debt is guaranteeing the interest rate that you're paying as your rate of return. If your student loans have a 6% interest rate, your cash is "earning" you 6%. Over long-periods of time equity markets have historically returned 8-10% so you'd be better off putting more towards your 401(k).
However, you also want to take into consideration other goals you may have. By reducing your amount of outstanding debt faster, you'll sooner be able to qualify for a larger mortgage if buying a home in the near future is a goal of yours.
Hope that helps.
First, make sure you have cash reserves (in the bank) of 3 - 6 months’ worth of living expenses (net of taxes and savings). Second, pay off any/all debt (student loans, credit cards, etc...) that is costing you more that 5% per year. Finally, invest at least enough into your 401(k) to get the maximum match, and if you can save more, even better.
One thing you don't mention that you are doing -- but obviously you are -- is living modestly. Even though it may not seem like it, you are already putting your spare money into savings. It's just that at this point in your life, "savings" means reducing debt. So what you are asking is if it makes sense to put money into savings in a different way -- your 401k -- and my answer is "probably yes." I say, "probably" because you don't tell us what the interest rate is on your debt. I am advising you to put as much as you can into the 401k, at the expense of debt principal if necessary, because (1) you can earn a better return than your interest rate; and (2) the tax savings is meaningful to you. (You also don't say if your employer matches your contributions. If they do, that cinches it. You should take as much of an advantage of that as you can afford.)
One of these days your student loan will be gone. When it is, its absence will represent a "raise" that you can apply to your lifestyle. Meanwhile, your 401k will have been growing and will be in healthy shape. By the time you retire you will need liquid investments of 20 times your living needs. So put away the money now and you will be very glad you did.