Should I Save For Retirement Or Pay Off My Student Loans?
Graduates with student loans only accumulate half as much as their non-debtor peers in retirement fund assets by age 30. If you are a student debtor, don’t overlook this retirement savings trick.
The reality is: 44 million Americans holding over $1.5 trillion in student debt are facing more pressing financial concerns than saving for retirement — and many are neglecting it. A recent study by the Center for Retirement Saving at Boston College found that student debtors save far less for retirement than their non-debtor peers by age 30. Young professionals who graduated with student debt have an average of approximately $9,100 in 401(k) retirement assets by age 30, whereas graduates who never had debt manage to save and accumulate twice as much, approximately $18,200, by age 30.
Most student debtors are not debt-free by age 30 and may continue to contribute less in subsequent years. Because of this, and because of the power of compounding interest, it seems likely that this retirement savings gap will grow even larger over the subsequent decades of a debtor’s life.
Curiously, the study found no correlation between the amount of student debt held by each graduate and the amount that retirement savings were reduced. Whether a student’s debt burden was large or relatively small, the retirement savings shortfall was approximately the same. The study’s authors offer one possible explanation: “This result suggests that young graduates consider the simple existence of a student loan — rather than its size — to be a constraint on their 401(k) saving.”
If you have student debt, should you contribute to a 401(k) retirement plan? Or, should you focus exclusively on paying down your student debt as quickly as possible?
As a former six-figure student debtor, this was one of my primary questions when I started working. I decided to skip the 401(k) and focus all of my efforts on my debt until it was gone. While saving for retirement in your twenties and thirties allows an investment to grow and compound over decades, paying off an outstanding debt — and stopping it from growing larger with interest — offers a guaranteed return. Mark Cuban recently shared similar advice: “Whatever interest rate you have — it might be a student loan with a 7 percent interest rate — if you pay off that loan, you’re making 7 percent. That’s your immediate return, which is a lot safer than trying to pick a stock or trying to pick real estate, or whatever it may be.”
While it is rational for some to prioritize student debt over retirement savings, that is not true across the board. My situation was unique for two reasons: (1) my employer did not offer a 401(k) match (so I was not leaving “free” money on the table), and (2) I opted to remain in the default student debt repayment plan and overpay each month, in an attempt to pay off my debt as fast as possible. However, if you have no chance of paying down your student debt in a reasonable amount of time (10 years or less), switching into an income-driven repayment plan may be the best option. And, for those student debtors in income-driven plans, there is an extra bonus for contributing to a 401(k) plan. By doing so, these debtors can reduce both their current payments and the amount of debt they have to pay overall.
Here is how this trick works:
More importantly, these payments aren’t just kicked down the road (as would be the case with putting off almost all other types of debt payment). In an income-driven plan, every dollar that you don’t pay towards your outstanding student loan balance is forgiven at the end of the repayment plan’s timeframe (i.e., 20 or 25 years). Of course, the IRS considers forgiven student debt to be taxable income, but paying a percentage of that forgiven debt as a tax is much better than having to pay 100% of it.
To illustrate: Imagine a student debtor saves and invests $5,000 in a 401(k) each year, and therefore pays $500 less in income-driven payments each year. After 20 years, this strategy would put $10,000 extra in the student debtor’s pocket ($5 x 20), and they would have paid $10,000 less towards their outstanding debt. If that additional $10,000 is forgiven at they end of 20 years, the student debtor will have to pay taxes on that phantom income, perhaps at a marginal rate of 22% or 24%, e.g., $2,200 or $2,400. That is over $7,500 in savings.