Dear Liz: I have about $16,000 in student loans at 6.8% interest. At the current monthly payment it would take me about 7.5 years to pay them off. I contribute 10% of my income to my company’s Roth 401(k) plan (my employer matches the first 6% contributed). I also contribute 3% to the stock purchasing plan. I am thinking of cutting back my 401(k) contribution to 6% and not contributing to the stock purchasing plan. Applying the extra money to my loans would reduce the payback period to about 2.5 years. After that, I would increase the contribution amount and diversify with a Roth IRA as well and maybe even begin the stock purchase program again. What do you think?
Answer: Not contributing to retirement accounts is usually an expensive mistake. The younger you are, the more expensive it can be.
Every $1,000 not contributed to a retirement plan in your 30s means about $10,000 less in retirement income. That assumes an average annual growth rate of 8%, which is the historical average for a stock-heavy portfolio.
In your 20s, the cost of not contributing that $1,000 is $20,000 of lost future retirement income. The extra decade of not getting those compounded returns makes a big difference.
People have the erroneous idea that they can put off retirement savings and somehow catch up later. Catching up, though, becomes increasingly difficult the longer you wait. A better approach is to save as much as possible starting in your 20s when the money has the longest time to grow. Then you’ll be in a better position to withstand job losses or other interruptions of your ability to save. If those setbacks don’t happen, you’d have the option of retiring early.
Granted, your plan would require reducing retirement contributions for just a few years. But the federal student loans you have are fixed-rate, tax-deductible debt that you don’t need to be in a hurry to pay off. In the long run, you’d be much better off boosting your retirement contributions.
If you’re determined to pay down your loans, however, use the money you’ve been contributing to the stock purchase plan. Continue making at least a 10% contribution to your retirement plan and increase that as soon as you can.
By my math, the letter writer currently pays about $227 per month on the loans and wants to increase that to $581. Since the increase represents 7% of his salary, he makes about $60K/year. That at least means that he’s not in danger of running up against the 401(k) contribution limits any time soon (if he were, then the answer would be a no-brainer: Keep contributing as much as you can to the 401(k) now, rather than contributing less now so that you can contribute more later).
It’s probably true that you’ll be better off financially in the long run if you don’t cut your retirement or stock-purchase contributions. (To know for sure, you’d have to be able to predict how your investments will perform over the next couple of years.) Still, the difference is not likely to be huge, and the psychological victory of being debt-free may be worth the monetary cost. I’m not sure either option is necessarily a “mistake.”
The most important question, as I see it, is are you really going to follow through with your plan? If you cut your savings contributions by $350, is all of that money going to go toward the student loans, or will some of it get diverted to other things that you “need”? Once you pay off the loans, is the money you’ve freed up really going to go back into savings, or will you find other reasons why you need to cut your savings rate “just for a few years”?
Putting off retirement savings and playing catch-up later can be difficult, but it is not impossible. The danger is that you keep putting them off, and “later” never comes.
People make a lot of irrational decisions that leave them worse off financially. One of those mistakes is going for the “psychological” benefits of accelerating repayment of non-toxic debt when everything we know about finances and math tell us they’re better off taking advantage of retirement savings opportunities. We need to stop coddling people with the idea that it’s possible to get back lost opportunities to save–it’s not. The idea of “catching up” after missing so many of those opportunities is, for most, a cruel joke.
Would you be better off paying off credit cards or making 403b contributions?
Ideally, you’ll do both. But the retirement contributions should be your top priority. Even without a match, putting money in your 403(b) gives you a tax break of 15% to 50% (depending on your tax bracket) plus all the future compounded growth you’ll achieve.
If the letter writer’s plan was to reduce retirement contributions to 0, I’d be more inclined to agree with you. It’s important to save for retirement continuously throughout your career. But he’s planning to continue to save 6%, which becomes 12% after the employer match. And up until now he’s been saving 19% (including the employer match and the stock purchases), which suggests that he’s probably ahead of where he needs to be for retirement. That’s not irrelevant.
Making extra payments on a debt is essentially equivalent to making a conservative investment. In today’s low-interest environment, an investment that pays a fixed 5% or so (6.8% minus the tax deduction) is a very attractive option. It’s still important to diversify with plenty of stocks that have better potential for long-term growth – but again, the letter writer is doing that.
And to get slightly pedantic about it, at the end of the day, psychological benefits are the ones that matter most. The purpose of saving money – the purpose of money, period – is to increase your well-being now and in the future. There’s no prize for checking out of the game with the biggest nest egg.