Financial Prioritization: Pay Down Debt or Invest in 401K?
I met up with a couple friends of mine last night, and the topic of investing and saving came up (funny how often that comes up…).
One of my friends, Steve, was wrestling with a question many people are facing: Do I use extra cash I have to pay off my student loans or invest in stocks to try and get a higher return?
His position was that he should invest in stocks as he could get an average 7% return on his money, whereas if he used his funds to pay off his loan debt, he wouldn’t be earning that 7%. Definitely a very reasonable point of view.
However, when I probed deeper, I learned that the average interest he was paying on his student loans was about 6%, close to his expected stock market returns. Further, rather than investing in a tax-advantaged retirement plan, he was investing in mutual funds through a taxable brokerage account.
To frame the problem at hand, I told Steve to take a hypothetical $10,000 he has and to invest in three different options. Option one would give him a guaranteed 3% return on his investment over 10 years. Option number two could earn him 7% per year, but it could also result in him losing money over that 10-year period so that he had less money than he started with. Option three could also earn 7%, albeit not guaranteed, but he also could not access that money until he was 60 years old. The upside of three is that he could reduce his tax bill by about $2,000 over that time. I asked him how he’d rank each of the options.
“The first option looks OK, because I value safety, and it’d be nice to know my investment would be secure,” he replied. “Number three looks great because of the tax benefit, but I can’t imagine only being able to access that money 30 years from now.”
“Well, do you think you’d need this money in the next 5 years or so? Because if you do, you should know that while the average stock market return is 7%, it varies widely from year to year. You might be up 20% one year and down 20% the next. There’s always a chance that you’ll have less money than you started with if you invest in stocks. However, that risk falls the longer you’re invested in the market,” I replied.
“So, since I might need the money soon, it might not be best to invest in something risky like the stock market. But if I don’t need the money in the near future, I can invest in my retirement plan and get a tax break now.”
“Exactly,” I said. “It’s still good to invest in stocks through a brokerage account. However, if you have a long term view, I’d prioritize your tax-advantaged retirement plans first.”
Steve was still a little unsure about option one. “Isn’t 3% a little low? I feel like I’ll be falling behind. However, I like the safety of it, and so few things in this world are guaranteed. So, I’d first prioritize option one, due to the guaranteed return, then I’d choose option two, since I get those tax benefits, and then option three would be OK since I could probably afford the risk after investing in options one and two. What does this have to do with my student loan problem, though?”
“Option one is paying off your student loans. You get a guaranteed return by paying off debt, one of the few guaranteed investments you can make. Option two is investing in your taxable brokerage account, which it sounds like you’ve ranked lower than option three, which is putting the money into your tax-advantaged retirement plan.”
Personal Financial Prioritization
The conversation above highlights how tough financial prioritization can be, since everyone’s situation is so different. However, I think ranking your options relies on a few key considerations:
- Interest rate on debt: High interest loans (10% annual rates+) should be paid off as soon as possible. This represents a guaranteed return on your money since you’re avoiding costs later on.
- Inflation rate/Consumer Price Index (CPI): Debt is a good thing to hang onto if inflation is rising — since your balance is static, its value falls as your income rises with inflation. A good example is housing: if you take out a $100,000 loan on a house, but the value of that house rises from $100,000 to $1 million due to high inflation, your debt has effectively disappeared.
- Income tax bracket: The higher your income, the more you benefit from tax deductions like 401K contributions. If you have a lower income, it might not make sense to prioritize those deductions over paying down high-interest debt
- Expected investment/stock market returns: This is somewhat linked to inflation, but generally, if the stock market is at a historical low point, it may make more sense to prioritize investing in the market (due to higher expected long term returns) over paying down debt. On the flip side, a richly-valued market may have more limited upside, meaning paying down debt might be a better option.
I’ve summarized these forces into a Financial Prioritization Matrix below to help you think about your own situation:
Financial Prioritization Matrix: Investment Returns vs. Income Tax Bracket
Based on the current environment of low inflation, richly-valued stocks and bonds, and a moderate income, this is my current prioritization:
- Emergency fund: At least 6 months of living expenses (rent, food, other necessities), ideally 12 months
- 401K match: Fund your 401K so that you get your full employer match, since this is free money
- High-interest credit card debt: Ideally, you should not be carrying credit card debt. However, if you are, pay it off as soon as possible
- Student loan debt above 7%: Paying this off will give you a guaranteed return, a rarity in today’s environment
- Tax-deductible 401K up to the $18,500 maximum: Contributing to the max can save you thousands of dollars on your tax bill, which you can then use for other investments
- Additional Roth or Traditional 401K: In addition to your primary 401K, you can save up to $5,500 per year in an additional tax advantaged account.
- Short-term savings: Savings for a big purchase, like a house down payment, in a safe investment vehicle like a CD or high-interest savings account
- Long-term savings: General savings, invested in a taxable brokerage account or a robo-advisor like Betterment.
What’s your financial prioritization? Feel free to share your thoughts in the comment section below.
Originally published at www.yourroaring20spersonalfinance.com on November 28, 2015.