It isn’t easy to decide between a 401(k) contribution and paying off student loans.
Each borrower has different financial circumstances, and some variables are impossible to know. Employment circumstances may change. The stock market may do really well, very poorly, or somewhere in between.
Fortunately, there are times when the decision is easy. Even when the decision isn’t obvious, most borrowers can find an efficient strategy by asking the right questions.
When You Should Definitely Put Money in a 401(k)
Some employers have excellent 401(k) plans. Specifically, they match employee contributions. These employers will even match, dollar for dollar, employee contributions. That means for each dollar you save, your employer will add a dollar to the account.
Less generous employer matching programs can still be a great deal for student loan borrowers.
Suppose your company will contribute 50 cents for every dollar you save. You are essentially getting a 50% return on your investment from day one. That is hard to beat.
When the Choice to Pay Down Your Student Loans is Obvious
Other people don’t have employers that match employee contributions. These people may have student loan interest rates well over 10%.
If you have an outrageous student loan interest rate, putting out that fire should be a priority.
It doesn’t make much sense to make an investment that you expect to earn 7% if your student loan charges 14%. Giving away a dime to make a nickel is a lousy strategy.
Adding Student Loan Forgiveness to the Equation
Many borrowers have federal student loans that may be eligible for some form of forgiveness.
For the borrowers chasing after forgiveness, putting money in the 401(k) becomes more appealing.
If the debt is on track to be forgiven, paying extra doesn’t make much sense. It just means less debt can be forgiven.
401(k) contributions provide additional benefits to the borrowers chasing forgiveness. By putting money in a 401(k), you lower your tax bill. The reduced tax bill means lower student loan payments. Lower student loan payments mean more money gets forgiven. Putting money in a retirement account to save money on student loans is one of my favorite student loan hacks.
Dealing with a Close Call
Unfortunately, the answer won’t always be obvious.
I like to think of student loan payments as an investment with a guaranteed return. If I pay an extra $100 on a student loan charging 7% interest, that $100 is earning a guaranteed return of 7%.
Many investments hope to earn 7% or better, but there isn’t an option out there that generates such a high guaranteed return.
Borrowers have to decide their willingness to accept risk. You have to weigh the fixed return on an extra student loan payment against the potential upside of investment growth.
A Note on Taxes: 401(k) contributions normally result in a lower tax bill. Additionally, student loan interest is a tax deduction. These tax factors may shift the scales enough to make putting money in a 401(k) the better decision. This is a good subject of discussion to have with your tax preparer at tax time.
Student Loan Refinance and Shifting the Numbers
One way to make a difficult decision easy is to refinance your student loans.
Suppose you decide 6.8% is the cutoff point for you. If your student loans are above that number, they get paid off first. Student loans below that interest rate take a backseat to 401(k) contributions.
Borrowers can refinance their student loans at a lower interest rate to free up money each month to save for retirement.
Presently, student loan interest rates in the 20-year, fixed-rate category are extremely low. Borrowers can lock in a low rate on their student loans and focus their efforts on building up their retirement savings. The catch is the borrowers need a decent credit score to qualify.
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