Deciding between attacking student loans and saving for the future in a Roth IRA is a difficult question.
Many student loan borrowers may lean towards eliminating debt first. Retirement is a battle for another day.
However, there are a couple of unique advantages to Roth IRAs that could make a Roth contribution a higher priority than debt elimination.
Comparing Interest Rates
One of the first considerations in the Roth IRA contribution vs. student loan payment question should be interest rates.
Borrowers with student loan interest rates in the 2-3% have more options to save for the future.
Historically, the average return for the stock market is around 10%. Some years the market will lose money and other years it will do far better than the 10% average gain.
A student loan borrower with a 2% interest rate on their loan can reasonably expect investments to earn more than the cost of the loan interest in most years. Thus, a borrower with an extremely low-interest student loan will usually be better off with a Roth contribution instead of paying down their student loans.
As student loan interest rates increase, the analysis shifts.
A borrower with a 7-8% interest rate loan might prefer to pay down their student loans first. Even though the market will historically return 10%, the risk might not outweigh the reward. Making payments on a loan charging 8% interest is like guaranteeing an 8% return on an investment. Many investors would gladly take a guaranteed 8% return over riskier market returns.
As investors get more experience, they will be in a better position to evaluate the potential Roth returns against the cost of letting a student loan linger.
The Big Roth IRA Advantage
There are many different types of retirement accounts. However, for student loan borrowers, a Roth IRA has an especially appealing feature.
Roth contributions can be withdrawn at any point without any taxes or penalties.
Roth IRA to Student Loan Example: Suppose I contribute $1,000 to my Roth IRA and let it sit for a couple of years. In that time, the balance grows to $1,200.
If my variable-rate student loan jumps up in interest, I might decide that I would rather use my Roth funds to pay down my student debt.
I can pull out the original $1,000 contribution and apply it to my student loan balance without facing any taxes or penalties. However, if I want to pull out the $200 worth of gains before I turn 59.5, I may have to pay taxes and a 10% early withdrawal penalty.
Ideally, I can withdraw just my contributions and leave the gains in my account to continue to grow until I reach retirement age.
The Roth perk here is flexibility.
If you put your money in a Roth account, you can always pull out the contribution and apply it to your student loans (assuming you haven’t lost money on your investments). Additionally, many people use a Roth IRA as an emergency fund. Going this route allows saving for retirement, but permits a penalty-free withdrawal in the event of a financial emergency.
If the money is used to pay down student loans, it is gone forever. Borrowers can’t get a refund on previous extra payments.
Risk Aversion and the Debate Between Student Loan Payments and Roth IRA Savings
Deciding between attacking student debt and putting money away for retirement isn’t a simple math equation.
A significant factor in the decision is risk aversion.
Some people are extremely cautious with their money while other people are literally gamblers.
Putting money in a Roth account has major advantages. However, there is a real possibility that Roth investments lose money. Savers can take steps to reduce risk in their investments, but any stock investment carries risk.
If the possibility of losses will keep you up at night, the guaranteed returns from student loan repayment might be the better option.
Dealing with High-Interest Student Loans
The final wild-card in the student loan payoff vs. Roth IRA debate is the option to refinance student debt.
Borrowers can use student loan refinancing to convert high-interest student debt into a lower-interest loan.
This route will only be an option for those who are employed and have a decent credit score. However, it is a great way to reduce interest spending and potentially free up cash for investment.
The best rates currently available are with the following lenders:
| Rank | Lender | Lowest Rate | Sherpa Review |
|---|---|---|---|
| T-1 |  | 5.28% | ELFI Review |
| T-1 |  | 5.28%* | Splash Financial Review |
| 3 |  | 5.49% | Laurel Road Review |
This is an interesting point about Roth IRAs I did not realize. Do you know if this applies to Roth 401Ks as well?
Great question Erik.
Unfortunately, Roth 401(k)s work a little bit differently. The early withdrawal described in the example would likely incur some taxation and early withdrawal fees.