How to Balance Paying off Student Loans and Saving for Retirement?
Let’s put aside the Biden administration’s prospective plans for federal student loan forgiveness. Assume you’ll need to pay the full balance of what you owe. Write that number down, then use a retirement calculator to determine how much you have saved for retirement. The two totals are necessary for the financial exercise outlined in this article.
So whether you’ve been with the same employer for a while or just completed a 401k rollover, this article will discuss how you can balance paying off your student loans and saving for retirement.
Step 1: Check your Loan Payment Amount and Interest Rate
The amount of your minimum monthly student loan payment is a permanent line item in your budget, at least until the balance is paid off. The total interest you pay on that balance will be determined by how long it takes you to pay it. Making additional payments above the minimum will reduce that total interest payment. What does that add up to?
You may be pleasantly surprised when you do these calculations. Student loan interest rates are significantly lower than credit card interest rates. Federal student loan interest rates range from 5.5% to 8.05%. The average interest rate on credit cards was 19.49% in 2022, and there have been several interest rate hikes since then. You might want to focus on paying off those first.
Step 2: Research Returns on your Retirement Savings Accounts
Loans come with a cost. Retirement savings accounts produce a return (most of the time). The question posed in this article is whether to focus more on paying off low-interest student loan debt or put your extra money into additional retirement savings. We’ve already established that you’re paying 5-8% on loan debt. What’s the return on your retirement savings?
Ironically, the average rate of return for a 401(k) over the next twenty years is projected to be between 5% and 8%, depending on the funds you’re invested in. The overall stock market return since 2002 has been 8.91%. The potential gain of retirement savings versus the potential loss of paying interest on a student loan are essentially equal.
Step 3: Review the Tax Implications
Steps 1 and 2 prove there’s no significant financial advantage to prioritizing student loan payments over retirement savings contributions. However, there are tax implications to both actions. To begin with, student loan interest is tax deductible, so you’re getting it back when you file your taxes. That’s a checkmark in the yes column for focusing on student loan debt.
On the other hand, 401(k) contributions are tax-deferred. They come out of your paycheck before taxes are assessed, reducing your current year’s tax liability. Contributing the IRS maximum of $22,500 per year might even put you in a lower tax bracket. That swings the pendulum back to prioritizing retirement savings. Once again, we are at an impasse.
The Bottom Line
Paying off student loan debt and saving for retirement are equally important. If you have extra money, focus on paying off high-interest credit card debt and other loans with higher interest rates than your student loans. Once that’s done, review the numbers again as we’ve laid them out here. Interest rates and investment returns vary over time. You might find that retirement contributions are more appealing when the market improves. Ultimately, the decision will depend on your personal preference and your financial situation.