eliminate student debt and build retirement at the same time

Making Retirement a Possibility Despite Massive Student Debt

Michael Lux Student Loan Blog 1 Comment

Retirement plans such as 401(k)s are built on the notion that workers can set aside a bit of money from each paycheck and expect to live reasonably comfortably in retirement. An essential component of this plan is powered by compounding interest. A little bit of money saved in your 20’s or 30’s can be a small fortune by the time you are in your 60’s.

Student loans pose a significant threat to retirements in the United States. How is a borrower supposed to save for the future when they are still paying for the past?

It may seem like student loans prevent retirement from ever happening, but it is possible to have a retirement despite large amounts of student loan debt. The key is to find a balance in planning for both goals.

Savers generate sufficient funds for retirement by getting their money to work for them. As time passes, interest accumulates, compounds, and balances grow. Borrowers, meanwhile, have time and interest working against them. Paying off student loans is like trying to hit a moving target. As you accumulate the funds to pay down the debt, the debt has grown.

The question for student loan borrowers becomes: How do I flip the script? How do I get time and interest working for me instead of against me?

The Most Important Thing…

“The best time to plant a tree was 20 years ago. The second best time is now.”Chinese Proverb
Get started now. Saving for retirement isn’t something that begins after paying off student loans. Elimination of all debt isn’t a prerequisite to saving for the future. Even on budgets strained to the max by student debt, it is possible to get the foundation in place to build a retirement.

It may be easy to dismiss retirement issues as future problems and focus on the present rather than worrying about far off events that might never happen. Subscribing to this line of thought can be a huge mistake. The tiny steps taken today can have life-changing consequences. It can mean not having to work into your 70’s. It can mean being able to get the necessary treatment for yourself or a loved one if someone gets sick. It can even mean being able to help your kids pay for school so that they don’t face the same hardships.

Retirement Basics and Terms to Know

Before getting into the strategy behind saving for retirement while also paying down student loans, it is essential to have an understanding of a few basic retirement concepts.

The terminology defined here is to serve as a very simple introduction. Savers are encouraged to educate themselves further before making any investments.

Retirement Vehicles – These are the accounts that hold retirement funds. Rather than being actual investments, retirement vehicles are the locations where various retirement assets are stored. They include:

401(k)s, 403(b)s and 457 Plans – These various retirement plans are accounts provided by employers. Though 401(k)s, 403(b)s and 457 plans have some differences in terms of eligibility and rules, for our purposes they are pretty much the same. These accounts allow individuals to put money aside for retirement before it is taxed. Savers do not pay taxes on their 401(k) until the funds are pulled out of the account.

Individual Retirement Account or IRA – An IRA works like a 401(k) as it allows individuals to set money aside for retirement before it gets taxed. The major difference is that employees are not dependent upon their employers to set up an IRA. Anyone can set up an IRA to save for their retirement.

Roth IRA – A Roth IRA works similarly to an IRA in that anyone can set up a Roth account. The major difference is that with a Roth IRA, the money going in is taxed, and it comes out tax-free. If you believe your future tax rate will be higher, a Roth IRA can be a great option to save money on taxes.

Brokerage Account – A brokerage account is an account that holds investments, but it does not come with any special tax advantages.

Retirement Investments – These are the assets that are purchased in the hope that they will have a greater value in the future. (These are the retirement assets stored in the previously described retirement vehicles.) Common investments include:

Stocks – When you purchase stocks, you are buying shares of ownership in the company. As the value of the company increases, the value of your shares increase.

Bonds – Bonds are financial instruments wherein the issuer of the bond borrows money from the investor and the issuer agrees to pay back the amount borrowed plus interest. Governments, banks, and many other companies can be issuers bonds.

Mutual Fund – A mutual fund is a collection of assets, such as stocks and bonds, managed by a financial services company. The idea behind a mutual fund is that it allows individual investors to own many different stocks and/or bonds in one affordable financial instrument. Target-date retirement funds are a common example of a mutual fund.

Risk – Any investment comes with risk, which is the chance that a particular investment could lose some or all of its value. Typically, the riskier an investment is, the higher the potential return, but the greater the chances of a loss. Government bonds are considered to be a very low risk while holding individual stocks is considered to be a higher risk.

Diversification – The greater the variety of investments held, the more diversified the individual’s account is said to be. By diversifying, savers can reduce long term risk while still generating solid returns. Some mutual funds, such as target-date funds are broadly diversified to reduce risk.

Now that we have covered some of the basic vocabulary, we can jump into the strategy for student loan borrowers…

Employer Matching Retirement Programs

Many employers offer retirement contributions to their employees through employer matching. Terms vary from one employer to the next, but the general idea is that for each dollar an employee contributes the employer will also contribute a dollar, up to a specific limit. This matching is usually associated with a workplace account, such as a 401(k).

Employer matching programs are designed with the idea of encouraging employees to save for their retirement.

From an employee perspective, these programs should be utilized whenever possible. If you have dollar for dollar matching, it means you are essentially doubling your investment from day one.

Due to the tremendous opportunity provided by employer matching, student loan borrowers should look to maximize their employer matching under just about any circumstance. Obviously, borrowers will want to make sure they are making minimum payments on all their loans, but after minimums are met, maxing out matching should be the next priority.

The math is fairly simple. Rather than using one dollar to pay down debt, that one dollar can immediately turn into two dollars when taking advantage of the employer match. That is a huge net gain for borrowers.

Unfortunately, employer matching is typically limited to a small portion of salary. As a result, the employer matching is a nice start, but not the end of retirement planning.

Student Loan Interest Rates vs. Earning Interest

The challenge for would-be savers and student loan borrowers is to strike a balance between earning interest to grow a retirement balance and paying down interest to eliminate student loans.

Most retirement investments come with risk and can produce a range of potential returns. Meanwhile, student loan debt has a reasonably predictable interest rate.

The question for borrowers is how much risk they are willing to tolerate. Investments can produce huge returns, but paying down student debt provides a guaranteed benefit.

Using Tax-Advantaged Accounts

Tax-advantaged accounts such as 401(k), 457 plans, and IRA allow retirement savers to put money towards retirement before paying any taxes.

This leaves student loan borrowers with a difficult judgment call. Suppose a borrower has $100 per month that they can either use for retirement or use to pay down student debt. If the borrower is in the 25% tax bracket, they can either put that entire $100 in a tax-advantaged account and save for the future, or they can pay taxes now and use the remaining $75 to pay down student debt.

On the surface, putting money in the tax-advantaged account seems like a no brainer. The problem is that when the money comes out, it will get taxed. This reduces some of the advantages to this account.

We typically suggest borrowers with extremely high-interest rate student loans, starting at about 10%, to aggressively pay down their student loans before making retirement contributions. Those with lower interest rate loans should consider setting aside money for retirement in tax-advantaged accounts before aggressively paying off their loans. Those that are investing in broad stock market mutual funds, such as an S+P 500 index fund, can expect an average return of 7-10% according to most financial experts, but those numbers can vary greatly from year to year and are dependent upon the nature and quality of the mutual fund.

Those who want to start saving for retirement right away but facing high-interest rate student loans should consider finding a student loan refinance company that might offer a lower interest rate. Going this route can save money on student loans and allow borrowers to grow a retirement balance.

Special Note for Income-Driven Repayment Plan Participants – Borrowers who are on a federal income-driven repayment plan such as IBR or PAYE can get lower payments by contributing to a tax-advantaged account. This is because these contributions lower an individual’s Adjusted Gross Income (AGI) on their tax return. A lower AGI means less discretionary income, and less discretionary income means lower monthly payments.

Utilizing Forgiveness Programs

Participation in student loan forgiveness programs can also influence retirement planning with student loans.

This is especially true for borrowers working toward Public Service Loan Forgiveness (PSLF). These borrowers can get lower payments by making retirement contributions which leave a larger loan balance to be forgiven after ten years.

Most borrowers will find that money goes further when saving for retirement instead of using it to pay down balances that would otherwise be forgiven.

Deciding Between Saving for Retirement and Paying Off Student Loans

The smart strategy is to attack high-interest debt first. Don’t worry about ultra-low interest; you can start saving before you eliminate all your debt.

A general formula for student loan borrowers would be to put their money towards the following:

  1. Employer Matching Programs
  2. High-interest student debt (~10% or higher)
  3. Tax-Advantaged Retirement Accounts (401(k)s, 457 plans, etc.)
  4. Medium Interest Student loans (~5-7%)
  5. Other Retirement Savings (Brokerage accounts)
  6. Low-Interest Student Loans (<3-4%)

Ultimately, the strategy will depend upon a saver’s tolerance for risk and the borrower’s desire to eliminate debt. Student loan forgiveness programs can also adjust priorities as can student loans refinanced at a lower interest rate.

The key for any individual is to understand their options. Whether saving for retirement or paying down student loans, the goal is the same: a healthy financial future.

Finally, it is critical that all borrowers…

Don’t Procrastinate!

Managing student debt and saving for retirement can both be stressful endeavors. They can also seem complicated. Student loan borrowers have to understand repayment plans, forgiveness terms, and lender rules. Retirement savers need to figure out the proper retirement vehicles and investments.

It is easy to dismiss these issues as future problems and focus on the present rather than worrying about a far off future that might never happen. Subscribing to this line of thought can be a huge mistake.

Most of this article discusses dollar allocation options, how income can be put towards retirement or how to pay down student loans. What we didn’t discuss is the fact that money can also be used for shopping, entertainment, or fun. There are certainly many more pleasurable ways to spend money, but retirement and debt elimination should both be top priorities.

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Ahhahahahahaha…. Great one!

Now tell me how someone who has never been hired to work for more than $14/hr that has a student loan from 2000 capitalizing at 8.25% can afford anything.

My Student Loan in 2000 was roughly $33,000. The Fed set it at 8.25%, which made my monthly payments $404.75.

I grossed $4,795 in 2000. Like I could pay $404.75/mo. I grossed $18,642 in 2001. $15,818 in 2002. $15,931 in 2003. $20,328 in 2004. $20,280 in 2005 and $22,880 in 2006. I didn’t break 150% of “Federal Poverty Level” until 2007. So for the first seven years after graduation my only options were Deferment & Forbearance.

Oh Look! IBR (Income Based Repayment) was started in 2007! I made $27,480 in 2007 (167.54% FPL) … my 25 year IBR payment was around $150 IIRC. Let’s call it $200. SO I get to cut my gross monthly earnings from $2290 to $2090. OK. And let’s see where that leads us…

Ah… at the end of the 25 years, I get to have my now $204,635.16 “loan” forgiven… which means, using my 2018 AGI and 2019 tax tables, I get a $46,076 Tax bill from the IRS… AFTER paying $60,000 ($200*300 months)

Wow. And given that my average annual income over the last 18 years has been LESS than $24K, what are the odds I could amortize “up” to a flat schedule?

Well, that would be $451.62/mo. So, I’d get to live on $1,548.38 gross/mo. AND I would have the pleasure of paying $112,453 total over 20 years. But at least I avoided “loan forgiveness” and the tax man, right? No! Going all 25 years at a mere $200/mo only costs $106,076‬ – a full $6,377 less! WHOOPEE!

This system was DESIGNED to crush people who couldn’t find professional work immediately, especially at higher interest rates, and keep them from ever getting ahead – all to increase the “asset value” of the “student loan debt”.

And it works smashingly well.

Oh, & FWIW… If I get a Wage Garnishment, (25% of discretionary income) it will only cost me around $100/mo until I die in 30 years give or take. That’s only $36,000 – or roughly equal what my original principal was. Gotta love math.