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 comfortable 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 major 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?
Savers generate sufficient funds for retirement by getting their money to work for them. As time passes, interest accumulates and 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 ProverbGet started now. Saving for retirement isn’t something that starts 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.
Before getting into the strategy behind saving for retirement while also paying down student loans, it is important 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 prior to 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 money is 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 is able to 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 agrees to pay back the investor in the bond the debt owed 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 more risky an investment is the higher the potential return, but the greater the chances of a loss. Government bonds are considered to be very low risk while holding individual stocks is considered to be higher risk.
Diversification – The greater the variety of investments held, the more diversified the individual’s account is said to be. By diversifying, savers are able to 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…
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 certain limit. This matching is normally 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 have been 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 in order 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 fairly 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 produces 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 advantage 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 prior to 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 afford borrowers the opportunity 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 individuals Adjusted Gross Income (AGI) on their tax return. A lower AGI means less discretionary income and less discretionary income means lower monthly payments.
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 leaves a larger loan balance to be forgiven after 10 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.
The Smart Strategy: 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:
- Employer Matching Programs
- High interest student debt (~10% or higher)
- Tax Advantaged Retirement Accounts (401(k)s, 457 plans, etc.)
- Medium Interest Student loans (~5-7%)
- Other Retirement Savings (Brokerage accounts)
- 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…
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, the ways in which income can be put towards retirement or to paying 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.