The Student Loans vs. 401(k).

By Bill Jackson December 26, 2023 12 mins read 164 Views

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By Dr. Jim Dahle, WCI Founder

I've given recommendations before about how you should prioritize investing vs. paying down debt. Behaviorally speaking, you're often better off paying down debt rather than investing. Mathematically speaking, there are times when investing makes more sense than paying down low-interest rate debt, even though paying off the debt provides a guaranteed return. Deciding between maximizing retirement accounts and paying off moderate-interest debt, however, can be a conundrum.

Let's talk about it today.

Good Reasons to Invest in a 401(k)

Here's why investing in a 401(k) can be such a good move.

Possible higher rate of return
Possible better asset protection (specific to the state and type of debt)
Tax advantages (deductible interest, retirement account benefits)
Maximizes tax-protected space

Good Reasons to Pay Down Debt

Of course, getting rid of debt also has plenty of pluses.

Known, guaranteed rate of return
Possible better asset protection (specific to the state and type of debt)
Improved cash flow
The feeling of being debt-free

More information here:

The Wrong Way to Think About Debt

In Defense of the 401(k)

Tax-Deferred Contribution vs. Moderate-Interest Rate Debt

General concepts are fine, but sometimes you actually want to quantify the benefits of each choice. There are a lot of variables, including unknown future returns, but if you are willing to make some reasonable assumptions about those, quantification of the benefits can easily be done.

Consider an investor who is deciding whether to contribute to their 401(k) or pay off an 8% student loan. Let's say they have $10,000, and they can take either option and have a marginal tax rate of 33%. First, let's quantify the benefit of making a 401(k) contribution. There are two ways you save on taxes by doing this. The first is that your money grows in a tax-protected manner. Since the investor's marginal tax rate is 33%, the reality of their 401(k) contribution is that 2/3 of the money in the account belongs to the investor and the other 1/3 of it is being invested for the government. After 30 years at 8% per year, their $6,667 is worth $67,088. If that money had been in a taxable account, it would have been worth, at most, $53,459. So, the tax-protected growth is worth $13,629.

The second way a 401(k) helps you save money is the arbitrage between your marginal tax rate and your effective tax rate. This investor saved money at 33% upon contributing. If their effective withdrawal tax rate is only 20%, the arbitrage is worth another $13,413, for a total of $27,042 more than they would have had in the taxable account.

The Comparison – 401(k) vs. Student Loans

To compare which is the better decision, let's consider two scenarios. In the first, the investor puts the $10,000 into the 401(k) this year and pays off the debt next year. In the second, they pay off the debt this year and put $10,000, plus the $800 in interest they saved by paying off the debt, into the 401(k) next year.

In the first scenario, the investor reaps a benefit of $27,042 by putting the money into the 401(k) and pays $800 in interest. In the second scenario, the investor saves $800 in interest and adds that to their $10,000 401(k) contribution in year 2. Twenty-nine years later, the investor reaps a total benefit of $26,550.

Even with a similar 8% rate, making the 401(k) contribution is the right move but not by much. What if the interest rate on the debt was 12%? Then, paying down the debt comes out ahead: $27,534 to $27,042. If the debt was at 5%, then the advantage for the 401(k) contributor grows to $1,229: $27,042 to $25,813. Keep in mind this is the advantage from just one year of carrying the debt and making a 401(k) contribution. If you continued to make this decision each year, the benefit (or loss) would continue to compound.

401(k( vs student loans

Paying down debt is never a bad thing, but when the interest rate on the debt is similar to the expected return on the investment inside the 401(k), you are likely to come out ahead by maxing out the retirement account instead of paying down the debt. Investing, of course, does involve taking on more risk, which should be taken into consideration. A guaranteed return of 5%-8% is nothing to sniff at. If your debt is at 8% but you only manage 6% on the investment, the benefit of the 401(k) contribution is essentially eliminated ($15,053 vs. $15,033).

More information here:

Paying Off Spouse’s Student Loans Together

Doesn't Matter Much

One observation I had after running all these numbers was how little it mattered. While there is obviously a great benefit to paying off a 20% credit card and borrowing at 1% while investing at 8% is essentially a no-brainer, it just doesn't matter all that much when you're talking about moderate interest rates. On a sum of $10,000, it is really only a $500-$1,000 (per year) decision, and one-year returns in the market are a crapshoot at best. The best option is probably to live like a resident until your student loans are gone so you can both max out your 401(k) AND pay off your student loans.

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Residents?

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What do you think? Have you had to decide between maxing out retirement accounts and paying off moderate-interest debt? How did you decide? Comment below!

[This updated post was originally published in 2014.]

The post The 401(k) vs. Student Loans Decision appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.

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By: The White Coat Investor
Title: The 401(k) vs. Student Loans Decision
Sourced From: www.whitecoatinvestor.com/quantifying-the-401k-vs-student-loans-decision/
Published Date: Tue, 26 Dec 2023 07:30:20 +0000