Now that you have started your career, you (hopefully) need to make a decision about how to allocate your excess savings. Should paying off your student loans be a higher priority than contributing to your employer-sponsored 401(k) or 403(b) plan?
Conventional wisdom suggests it’s always better to start saving for retirement as soon as possible to take advantage of compounding interest and just make the minimum payments on your student loans. Although there are good reasons to make retirement a higher priority, it is important to remember that it doesn’t need to be one or the other. Often the best approach is to do a combination of both.
Below are some of the key factors to consider when deciding how to allocate your resources between these two goals:
- Current Savings
- Employer Retirement Plan
- Expected Return on Investments
- Tax Implications
Before you start saving for retirement, or paying down your student loans, you need to figure out how much you are saving each month. Although it can be a tedious and time consuming task, it is important to put together a budget that projects your take home income each month and compares it to your budgeted expenses. Fortunately, there are hundreds of different software tools to help track your budget and expenses (e.g. Mint or Quicken).
Break your expenses into three main categories; needs, wants, and savings goals. It is ideal to keep your needs under 50% of your take home pay and your wants under 30% of your take home pay. The surplus (20%+) should be dedicated towards your savings goals and debt repayment.
Before aggressively saving or paying down student loans, you should set up an emergency fund. As a general rule, you should have at least 3-6 months of living expenses in a safe, accessible account. This will protect you from either a major unexpected cost (such as medical expenses) or to cover your basic living expenses if you get laid off or have a period of time in which you are temporarily unemployed.
Employer Retirement Plan
In the investment world, it is important to remember if something sounds too good to be true, it probably is. One exception to this rule is if your employer offers to match contributions you make to your 401(k) or 403(b) plan. Every employer plan is different, but a typical matching situation is for every dollar you contribute, your employer will match 50% or 100% up to a certain limit.
As a general rule, if you have excess savings you should take full advantage of your employer match because it is a great way to jump start retirement savings and nowhere else can you receive a similar guaranteed return on your investment.
Expected Return on Investments
When you are trying to decide between making additional student loan payments or increasing retirement savings, you should compare the interest rate on your student loans to your expected rate of return on investments.
Think of your student loan payments as an investment. When you make additional payments, you are essentially earning a guaranteed return on your investment equal to the interest rate on the loan because you are reducing the amount of interest you will pay over the life of the loan. Unlike investments, there is no risk associated with paying down debt because the return on investment is guaranteed.
There is an up-front tax benefit associated with contributing to a 401(k) or 403(b) plan because it lowers your taxable income. Unlike deducting student loan interest, there is no income limitation on this tax deduction. Generally, the higher tax bracket you are in, the bigger up-front tax benefit you will receive.
There is also a potential tax benefit associated with making student loan payments but it comes with a few restrictions. When you pay your student loans, you may be eligible to deduct the interest portion of your payments (up to a limit of $2,500/year) which reduces your taxable income. However, in order to deduct student loan interest on your tax return, your income needs to be below a certain threshold (see IRS reference). From a tax standpoint, it is advantageous to start making student loan payments as soon as possible if your income is below the threshold.
The Bottom Line
There are many factors to consider when making a decision about how to allocate your savings between retirement savings and additional student loan payments. Some additional considerations are student loan forgiveness programs and changing your repayment plan. Because everybody’s financial situation is different, and many factors need to be taken into account, following generic advice is often not the best approach.
Before making significant financial decisions, you may want to consult with a Certified Financial Planner™. Similar to a lawyer, many fee-only financial planners work on an hourly basis and charge a flat hourly rate.
By: Ryan Pace CFP® – July 16, 2014