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Old 09-11-2017, 11:19 PM   #1
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Default 401-K or pay off student loan?

So, my son started his first real job. We had a discussion today about whether it was financially better to put money into the 401-K or pay down his student loan. My recommendation - without running any numbers - said that you should at least put in the % that the company was going to match, but probably should max out your contribution %. Use whatever else you can to pay down the loan.

My logic:
The 'company match' money is free and outweighs the interest you'd probably pay on the loan for the year.

The 401-K is pretax, whereas paying the loan is post-tax, so if you're talking the same amount of money, then $500 in the 401-K is the same as $400 to pay the loan.

I think student loan interest is tax-deductible, so if you pay $400/year in interest it's actually going to be closer to $300 out of pocket.

Getting $$ into the 401-K early is going to pay off way down the road in compounding. If you delay 2 years then what you're really losing out on is the compounding in years 39 and 40, which is way more than your contributions in year 1 and 2, and that amount you make is going to be way more than the interest you'd pay today on the loan.

What would you recommend? I'm sure it's not really a "all one or all the other", but if you had to make a choice of $$ going to one vs the other what would you think is the best choice?

What else am I missing? I am going to run the numbers so I can prove it to him on paper - any suggestions on the best way to make it accurate?
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Old 09-12-2017, 12:39 AM   #2
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What's the loan rate?
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Old 09-12-2017, 03:28 AM   #3
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Do the 401k match amount first and then use whatever else to pay student loans.
Most student loans are between 5-7%.
The interest deduction is capped at $2,500 and it phases out starting with an income of $65k/yr.
Also, the market is pretty high, so the compounding for the next 3-5 years will likely be less than the historical averages.
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Old 09-12-2017, 03:35 AM   #4
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At his young age (early 20's I assume), I would forego the 401K for the time being and get that loan off of his back. I am a firm believer in no debt although I know none of us have avoided debt at some point in our lives.

He has plenty of time in front of him to max out a 401K
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Old 09-12-2017, 03:50 AM   #5
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I had the same thought. The issue is MOST folks will begin to find other uses for their money, new car, better place to live, engagement ring, etc. Your son may be different and this is entirely my opinion but as someone who had matching up to 5% I would say esp at his age put in as much as he can afford now. Later if necessary borrow from it and pay it back, I know I can with my TSP.

I ended up deploying with the Marines and paying off my loans in full, but had wished I had maxed out my TSP at age 21 moving forward.
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Old 09-12-2017, 04:06 AM   #6
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He should do a ROTH 401K, if available. Up to the match limit, then pay the loan.

Use accurate tax rates for your calculations, you are likely way high. And you'll find that he cannot deduct anything because he won't be itemizing...
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Old 09-12-2017, 04:07 AM   #7
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Quote:
Originally Posted by LI32 View Post
Do the 401k match amount first and then use whatever else to pay student loans.
Most student loans are between 5-7%.
The interest deduction is capped at $2,500 and it phases out starting with an income of $65k/yr.
Also, the market is pretty high, so the compounding for the next 3-5 years will likely be less than the historical averages.
This 100%. I would also remind him you can make more than one student loan payment per month which I found really helped. An extra $10 per week (basically a cost of lunch) adds up over 3-4 years.
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Old 09-12-2017, 04:30 AM   #8
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Later if necessary borrow from it and pay it back, I know I can with my TSP.
Borrowing from a 401K should be avoided.

He should also build a six month emergency fund reserve.
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Old 09-12-2017, 04:43 AM   #9
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First thing he should do is get on "Income Sensitive" repayment of the school loans. This will drop his min. payment quite a bit. He can still pay more to knock down the principle but he's not obligated.
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Old 09-12-2017, 05:20 AM   #10
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Simple: pay the loan down. Jobs may come and go, but that loan will not go away no matter what happens. Best to finish it early rather than later at that age.
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Old 09-12-2017, 05:23 AM   #11
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I think you are looking at it right but it Also depends on How much he owes and what his earning potential is. What does he do for work?
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Old 09-12-2017, 05:26 AM   #12
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Assuming he plans on staying with his current company long enough to be vested, I would contribute whatever it takes to get the maximum match. I've never understood people who leave free money on the table.
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Old 09-12-2017, 05:28 AM   #13
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Quote:
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First thing he should do is get on "Income Sensitive" repayment of the school loans. This will drop his min. payment quite a bit. He can still pay more to knock down the principle but he's not obligated.
Very bad idea unless the current payments exceed his ability to pay them back.

Income sensitive equates to negative amortization meaning that 10 year student loan will eventually be paid off when he is in his 40's.
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Old 09-12-2017, 05:31 AM   #14
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How much is the student loan? We talking 20-30k or 100k?

If it's the former then I'd say forget the 401k for now and pay the loan off in less than a year. If it's the latter then maybe start the 401k up to the match and then pay the loan...or if he can pay that much off in a couple years then do that instead and again skip the 401k. Won't hurt his retirement. The "free money" ain't gonna be enough to really make a difference. Probably a couple thousand per year. Big whoop. I make pretty good money, and I can save the entire company match for a year in less than a month. Doesn't really move the needle to miss it for a year.

The tax deduction is a farce. For one thing, he won't be eligible for it as soon as he starts making good money. The other thing is your going to pay more in interest than you'll save on taxes.

(Same argument applies to mortgage interest tax credit by the way...complete nonsense...and also fails to consider risk).

He's young and if this is his only debt I'd say sacrifice everything to pay it off in a year or two and never borrow another dime for anything that isn't a 15 year mortgage. That's damn sure what I wish I would have done coming out of school. The only thing we have left is my wife's student loan which has been around so long it's part of the family. We are destroying it and it'll be gone by December. Finally! And that's the last debt we will ever have that's not our house.

Make him read the millionaire next door. Get the debt cleared and then follow those principles.

Don't spend time worrying about opportunity cost, debt interest vs investment interest, or any of that other nonsense used to justify keeping debt around.
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Old 09-12-2017, 05:37 AM   #15
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Simple payoff debt FIRST! It's return is guaranteed After debt is erased pile on the 401k and max out if possible.
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Old 09-12-2017, 05:50 AM   #16
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Quote:
Originally Posted by LI32 View Post
Do the 401k match amount first and then use whatever else to pay student loans.
Most student loans are between 5-7%.
The interest deduction is capped at $2,500 and it phases out starting with an income of $65k/yr.
Also, the market is pretty high, so the compounding for the next 3-5 years will likely be less than the historical averages.
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Old 09-12-2017, 05:50 AM   #17
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The answer seems pretty clear to me. Build some cash reserves, maximize match portion of 401k and excess to debt. Control discretionary spending. Use a credit card to build credit rating.


I would not give up what is essentially a 100% return on my initial 401k investments in year one.


debt is not the boogeyman, but high interest rate leverage can be.
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Old 09-12-2017, 05:50 AM   #18
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would help to know the size of the loan and rate, but U would certainly claim the match on the 401k. Free money is tough ti come by, and its a great habit to start.
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Old 09-12-2017, 06:12 AM   #19
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Also, the market is pretty high, so the compounding for the next 3-5 years will likely be less than the historical averages.
Didn't someone (not you) say this each year for the past many years?
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Old 09-12-2017, 06:17 AM   #20
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Without other pertinent info,

If your son saves $2500 a year for 3 years and the company matches that $2500. With a 7%AAR he would have $210,000 in 40 years. (With no additional contributions)

If he waits three years, same parameters as above, he will have $171,000 in 37 years. Waiting three years will cost him $39,000. Obviously, if he saves more and the company matches more, the $39,000 number could be much bigger.

The power of compounding, if you squander it, it is lost.




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