I’ve already written about tax-efficient investing and whether you should pay down debt or put money in a brokerage account. However, I haven’t focused enough on whether you should save for retirement or pay student loans. Getting the answer to this question could be the difference between you having millions of dollars or simply having a mildly positive net worth.
I’m going to outline a priority of where your money should go so you can measure your success against others and know that you’re going to be financially secure one day.
Priority 1: Pay the minimum owed on your student loans
While you could use forbearance or deferment for your student debt, you can only do that temporarily. If you’re struggling financially and have to make a choice between save for retirement or pay student loans, I prefer if you prioritize making the minimum required payments on your loans first.
Purists who always tell you to get your retirement match first might vehemently disagree about this advice.
When you owe student debt, you’re either struggling, doing ok, or having lots of success financially.
If you’re struggling, you want to avoid delinquency or default so you don’t wreck your credit. Yes, not getting your 401k match hurts, but it’s much worse to have a credit score in the mid-500s instead of low 700s, buy a house with a mortgage, and pay tens or hundreds of thousands of dollars in unnecessary interest just to capture a couple extra thousand bucks in your 401k.
Also, early on in your career, your payments could be a fraction of what they’ll be later. For example, say you’re a resident physician debating where to put $300 a month. You could defer and put the money in retirement and get an extra $300 (pretend the employer offers a match even though it’s uncommon for residents).
Alternatively, you could sign up for Pay As You Earn (PAYE) and get credit towards PSLF.
When you get payments credited as a resident, you’re avoiding extra payments at a higher income later. Hence, you could pay $300 now or possibly $3,000 a month in five to six years as an attending physician.
Pay off student loans or invest? Would you rather have $300 today or an extra $2,700 in five to six years? This is why it’s so important to get your minimum student loan payments started.
Keep in mind that the math varies based on the profession, but this is a good general rule.
Also, when we talk about these first two priorities, both are extremely important. Imagine you had a patient that needed two very important medications. You’d prioritize if you had to, but you want them to do both.
Priority 2: Get your employer retirement match
Most employers offer something called a “retirement match” to incentivize you to prepare for your future retirement.
One of the most common offerings is the 4% match. Your employer will contribute up to 4% of your pay to your retirement account as long as you put in that amount too.
If you’re only saving 2% towards your 401k, you’re leaving 2% of your pay on the table every year for no reason.
Other employers will do things like a 50% match on contributions up to 6% of your salary. That works out to you contributing 6% and they contribute 3%.
Whatever the rule is, figure it out and make sure at a minimum you’re getting the whole retirement match.
Priority 3: Max out your retirement savings
I strongly believe that you should first focus on maxing your 401k, 403b, and 457 accounts at work over putting the extra dollars towards student loans. There are a couple reasons for this.
Pretend you have a student loan at 5% interest with a 10-year repayment period. Many people assume that the return you get by paying extra payments on the loan is 5%. That’s not the case because of effective interest rate math.
The actual effective rate would be about 2.44%. That’s the compound equivalent rate you’d have to earn on an investment to justify investing instead of paying down debt.
Since that’s fairly easy over a long-term time horizon, the answer to the “pay down debt or invest” question is usually invest, if you’re only looking at math.
Of course, that 2.44% is an after-tax equivalent yield. If you’re in a high tax bracket, that might be like earning a risk-free 4% in Treasury bonds. Since government bonds yield around 3% as I write this and carry duration risk, paying down debt is a better investment than putting money in bonds. However, putting money in long term stock index funds is likely better mathematically.
Have I lost you yet? I just wanted to throw in a bit of technical discussion to back up my statement.
Pre-tax retirement savings give you a deduction of up to $19,000 in 2019 for 401k or 403b plans. You get an additional $19,000 deduction if you can contribute to a 457.
Maybe you’re self-employed? If so, you might be able to contribute up to $56,000 pre-tax to a solo 401k or SEP IRA.
Finally, most people don’t know this, but Health Savings Accounts (HSAs) are essentially pre-tax retirement accounts too. A family can contribute $7,000 in 2019 to this account.
My advice to you is that you should focus on getting to a place financially where you can make your minimum required payments on your student loans and max all available retirement accounts. Then you can move on to the next level of wealth building.
Priority 4: Pay down student loans if you should or invest in a brokerage account if forgiveness is better
The next step of wealth building behavior that you should depends on what your student loan plan is.
If you work in a private sector job and your debt to income ratio is below 1.5 to 1, then you should probably refinance your loans.
After contributing the max to retirement accounts, you should pay down your student loans as aggressively as possible if the math says you should.
No one should hold onto student debt for a day longer than they need to. If it’s clear refinancing and getting rid of your debt is the way to go, then by all means get aggressive and try to rid yourself of student loans in less than 10 years. Honestly, I’d prefer if you paid it all off in five years or less.
However, if you decide you want to try for forgiveness under PSLF or an IDR plan, then paying extra on your loans is silly.
If you’re investing, set up an automatic contribution to your account so that you don’t have to think about anything.
How powerful is saving for retirement instead vs paying student loans?
Assuming you earn $100,000 per year, get a 4% 401k match, contribute $19,000 to your 401k, $7,000 to your HSA, and earn 7% per year on your investments, how much money would you have in 30 years?
We’re also assuming your contributions never go up with inflation.
The answer is: you’d have $3.03 million.
This is one reason why if you have huge loans that you need to use forgiveness for, you should focus on your assets being larger than your liabilities.
If you need to pay off your student debt, then you need to make sure you put away money for other goals along the way.
Should you save for retirement or pay student loans?
I’ll tell you that if you develop the habit of maxing your 401k every year and celebrate when you do it, you’ll be very well off one day.
If you pay off your student loans, then that’s a big accomplishment but you won’t be able to retire because of it. Should I contribute to my 401k or student loans.
If you’re unsure of whether you should go for forgiveness or complete pay off, get in touch because we’d love to make a custom plan for you.
Are you investing or paying off your student debt first? Which one do you think is more important?