pay student loans or save for retirement

Saving for Retirement vs. Paying off Student Loans

Michael Lux Best Of, Blog, Student Loans 8 Comments

The retirement vs. student loans debate doesn’t have one simple answer.  The reality is that a number of different factors can affect your personal situation.  By carefully reviewing the following six variables, you can be on your way to the smartest allocation of your money.

First variable: Your Student Loan Situation

Before you decide on how much to put towards your retirement, the first step is to make sure you have your student loan debt in order.  Making sure you are meeting your monthly obligations is essential as failure to do so can result in late fees and be devastating to your credit score.

Second variable: Taxes

Many retirement contributions, such as those to a 401(k) are done on a tax deferred basis.  This means that if you are making $50,000 a year and contribute $10,000 towards your retirement plan, the government will only be taxing you on the $40,000.  The government taxes this money once you are retired and withdraw it from your account.

However, they money you use to pay down your student loan principal must come from your after tax income.  Going back to the $50,000 income example above, if you don’t put that $10,000 towards retirement and instead plan on using it to aggressively pay down student loans, taxes will get in the way.  That $10,000 before taxes is only worth $7,500 after taxes, assuming you are in the 25% tax bracket.

Essentially, your tax analysis comes down to when you expect to be taxed at a higher rate.  If you think you pay greater taxes now than you will in your retirement, it makes sense to defer as much of your taxes as possible.  If you expect to be paying more in taxes in your retirement, it makes little sense to defer.

Third variable: The interest

When you save for retirement, interest works for you, growing your balance.  When you have student loans, interest is working against you.  When you are saving for retirement and trying to pay off student loans, because these interest rates are competing, it is important to look at the interest to see where your money is better spent.

If you have high interest rate student loans, such as those at 10% or above, your retirement account will likely not be able to keep up with the growing student loan interest, so there is more urgency in paying down this debt.  On the other hand, if your student loan interest is at an excellent rate, such as 3%, you might expect your 401(k) to perform better, so putting money towards your 401(k) might bet the better option.

It is important to keep in mind the many variables with interest.  Student loans can have variable interest rates and depending upon how your retirement is invested, the return can be very volatile.  One way to look at this decision is do you want the risk/reward associated with your retirement investments or do you want the guaranteed value offered by paying off your student loans.

Fourth variable: Employee Perks

Does your company match 401(k) contributions?  Do they contribute to your student loan payments?

These programs can tip the scale solidly in one direction or another.  Before you make any decisions or do your math, it is critical to know exactly what options you have, and how these programs work.

If your employer is going to give you extra money, it could dramatically shift your financial math.

Fifth variable: The Limits

This year the maximum 401(k) contribution is $17,500 (for those above age 50 it is $23,000).  For many who are still struggling with student loan debt, they are in no danger of hitting this maximum… this year.  However, the 401(k) limits are in place every year.  If you will be contributing the max in the near future, it may make more sense to contribute to the 401(k) now, carry student debt a little longer, and get the most out of the 401(k) contribution limits.

Another limit to consider is any prepayment limits that may be on your student loans.  The federal government as well as most private lenders do not charge a prepayment fee, however, they do exist.  If you have a limit to how much you can pay down your student debt, this fee can alter your calculations.

Sixth variable: IBR and PAYE considerations

Are you planning on student loan forgiveness?  If you want to maximize the benefit, putting your money in your retirement account can have its perks.  The monthly payment in the income based repayment plans is calculated based upon your adjusted gross income (AGI).  Money put towards your 401(k) is not included in your AGI.  Reducing your AGI means lower monthly payments on your student loans under IBR and PAYE.  Essentially 401(k) contributions work for you in two ways: you save more money for retirement and you lower you monthly student loan bills.

How do they all fit together?

Analyzing this situation doesn’t boil down to a simple calculation.  Rather, it is a question of how much risk you are willing to accept, how accurately your project your future financials, and a bit of luck.

With so many variables in play, it would be irresponsible to say there are any hard and fast rules when it comes to saving for retirement or paying off student loans.  For many, unless the scales are dramatically shifted in one direction or the other, a balanced approach could be the most prudent choice.

  • side_hustle_sally

    All good points to consider, especially being sure to take advantage of any employer match offers fro your retirement plan.

  • What a great, thoroughly researched article. I always assumed that you should always pay off loans first.

    • Thank you so much for the kind words. For many, paying of loans first is the best approach, but it really can vary from situation to situation.

  • Awesome. This really wrapped my head around other factors involved in this. Thank you.

  • I always go back and forth between the two options. It’s pretty important to at least contribute up to the match for your 401k if possible. A lot of people I’ve spoken to somehow think 6% is going to make a very large difference in their paychecks, but it really doesn’t as long as you aren’t falling behind on your loans. I’m glad you put all of these variables into one list. Nice job!

    • All great points. That 401k matching is something that your really don’t want to pass up. It is free money that you are declining… there really needs to be a good reason to say no.

  • Komrad

    On top of the numbers, there is the psychology. Currently I’m contributing up to the match for 401k and putting the rest on student loans, but delaying retirement savings would get rid of the debt faster.

    I’m going to lose sleep either way. If I stop saving for retirement, I’ll be stressed about my future. If I pay off student loans slowly, I’ll lose sleep over the weight of the obligation until it is gone.

    When I hear about doctors and other professionals who financed their education with hard work, savings, and scholarships, it makes me wish I had had the wisdom to get my education that way instead of borrowing.