This is a guest post by Liz Stapleton. She is a recovering attorney and freelance writer focusing on personal finance, entrepreneurship, and issues facing lawyers. Since starting her personal finance blog, Less Debt More Wine in 2014, Liz has paid off all of her credit card debt (over $10k), raised her credit score from 640 to 800+, and paid off one of her many student loans.
I had written a post already on my own save vs. pay off loan debacle. Liz does a nice job guiding you on how to make your decision.
What to do when you want to save for your future, but you are still paying for your past?
After spending so many years in school to get a professional degree, chances are you are already behind on saving for retirement. At the same time, along with a big shiny degree, you have a ton of student loan debt that will hamper your ability to save.
The problem is time. As you know from your student loans, interest can make a big difference in what you owe, or in the case of saving what you earn. The longer your money is in a retirement account, the more time it will have to grow.
Unfortunately, the same goes for your debt, the longer you have it, the more you pay. So which should you focus on first?
Why You Should Prioritize Debt Repayment
I recommend prioritizing debt repayment for two reasons but also with some exceptions. First, the interest rate on your debt is likely higher than the amount of interest you would earn on any investments. Second, if you are on an income-driven repayment plan and are planning on loan forgiveness, you may be in for a big tax bill.
Debt Usually Costs You More
Interest rates for debt can vary widely. Student loans for professional degrees usually range from 6% – 8%. The return on retirement investments usually ranges from 5% – 8%. However, that is over the long term, and you never know what is going to happen with the market.
For example, if you have a student loan (one of many I’m sure) with a current balance of $50,000 and an interest rate of 8%, you are paying $4,000 in interest in a year. If you were to max out a 401(k) retirement account, meaning you contributed $18,000 and earned interest at 6%, you would earn $900 from interest.
While $900 is nothing to sneeze at, to prioritize saving at a lower or even equal interest rate would require you to pay to save.
Loan Forgiveness through Income-Driven Repayment Plans isn’t Forgiveness
As the current law stands, any forgiven amount after the repayment terms ends for income-driven repayment plans such as Income-Based Repayment, Income-Contingent Repayment, PAYE, and REPAYE is considered taxable income.
This means that if worst case scenario, your monthly payment does not even cover the amount of interest that accumulates each month, then your loans could be growing. If your loans grow for 20-25 years, you are going to be taxed as if you made potentially hundreds of thousands more.
There is one exception to the loan forgiveness tax bill, and that is Public Service Loan Forgiveness (PSLF). Under PSLF after 120 qualifying payments, your loans are forgiven and not considered taxable income.
Why You Shouldn’t Forgo Saving for Retirement Entirely During Debt Repayment
While it’s likely a good idea to prioritize debt repayment now, it doesn’t mean you shouldn’t set aside some money for retirement. There are three reasons you should save for retirement while paying off debt.
First, time is money, the longer your money sits in your retirement account, the more compound interest you will earn. Second, you could potentially save free money; many employer-sponsored retirement accounts offer matching contributions. Third, saving for retirement could lower your tax liability.
When it comes to compound interest, every little bit counts
Let’s say you put $100 per month towards retirement savings. If your investment of $1200 earns a conservative 5% then at the end of the year it will become $1,260. If you stopped contributing that $1,260 would turn into $1,531 after five years. In 15 years it would become $2,494, doubling your money. If you had kept contributing just $100 a month, you would have saved $28,389 after 15 years.
Even if you aren’t maxing out your retirement contribution during debt repayment, just a small monthly contribution done consistently can go a long way.
You Never Want to Lose Out On Free Money
If you have an employer-sponsored retirement account such as a 401(k), you should educate yourself on any matching contributions they are willing to make. For example, my old company used to match a 5% contribution 100%. If I put in $5, my company would put in $5. I essentially doubled my money just be contributing to my retirement account.
You Could Pay Less in Taxes
While it is true that you can deduct up to $2,500 of the interest you pay on your student loans from your taxes [Editor’s note: Almost all doctors are over the income limit for this deduction]. You can lower your taxable income even more by saving for retirement. While there are lots of different retirement accounts (401k, 403b, TSP, IRA, Roth IRA, etc.), some of them are pre-tax contributions.
Pre-tax contributions allow you to put money that has not been taxed aside for your future in a retirement account. The government will tax those funds when you withdraw the funds from the account. If you make $75,000 per year and you put a total of $5,000 of pre-tax dollars into your 401(k) you will be taxed as if you earned $70,000.
The Exceptions to Prioritizing Debt Repayment
There are some circumstances where you might want to prioritize saving for retirement over paying off debt. For example, if your debt interest rates are in the 2%- 3% range your money might be better-used saving. Alternatively, if you can afford the loan’s standard repayment plan then paying that standard monthly payment and saving more for retirement will likely put you ahead on savings, without losing too much money to interest on your debt.
What do you think? Comment below.