You’ve recently graduated (or maybe you’ve been out of school for a while) and everyone — your friends, family, your broke uncle Tom and financial experts across the land all echo the same message:
1. Start contributing to your 401k immediately!
2. Compound interest is king!
3. Your employer's match is free money!
So, following conventional wisdom, we begin contributing to our 401k, usually up to the employer’s match, while making concurrent payments towards our student loan. It’s definitely what I did when I was younger. Fast forward 8 years later and life kicks our ass: 68% of Americans have an underfunded 401k, our student loans end up in forebarence, we have a $500 a month car loan, no money in our emergency account, and the only light we see at the end of the tunnel is an oncoming train. How did we end up like this? We were just following the directions of our friends, family, financial experts and society. We just wanted to take advantage of that employer match!
Pay off your student loan debt first
Paying off your student loans before contributing to your 401k will not make you broke. Paying off your student loans before contributing to your 401k will not cause you to lose out on wealth creation opportunities. Let’s take a look at one example, Go-getter Steve:
The profile of Go-getter Steve isn’t as uncommon as you think. Steve is 35 years old, he’s been out of college for 5 to 8 years, has a household income of $100,000 (combined) but has an aggregate student loan balance of almost $66,000 at 6%. He has a really awesome 401k plan with his employer that matches 100% of the first 6%. He’s crushing it at work, averaging a 5% annual salary increase, but he also knows that his household income will never be over $200,000/year, which he’s ok with, he knows that in order to make more than $200,000 would mean spending less time with his family. To Steve, more money just isn’t worth it. Despite being in the top 5% of income earners, he’s late to the retirement game, and at the age of 35 has nothing in his 401k. He wants to fix this by contributing 15% of his post-tax income into a roth 401k while paying his student loan debt down over a 10 year period.
What should Steve do?
Steve really has 2 options:
Option 1 - Contribute to his 401k while paying off student loans Option 2 - Pay off student loans first then contribute to his 401k
Society and conventional wisdom says Steve should contribute to the 401k now and deal with the student loan debt well into his 40s. That sounds horrible, no thank you. We can see that taking the time to conduct an analysis of the two options proves the net impact to Steve’s retirement portfolio is negligible. Because there is no impact to Steve’s final portfolio, Steve (and most Americans) should proceed with option 2 and pay off the student loan balance before investing his 401k.
Option 1 — In Detail
Let’s say Steve follows conventional wisdom and decides to pay his $66,000 loan off in 10 years. He’ll pay $732 a month, or $8,788 a year for a total payoff to Uncle Sam of $87,928 — ouch.
Steve is contributing 15% of his income, and his employer is matching 100% of the 1st 6% over this same 10 year period. Steve contributes $15,000 to $19,000 of his post-tax dollars to his 401k each year, while his employer contributes $6,000 to $9,500. His 401k is growing at an average of 10%. At the end of year 10 he will have approximately $432,000 in his 401k and his student loan will be paid in full. Steve needs to have money and live his life over this same 10 year period, so we’ve made sure that Steve’s free-cash-flow for non-student-loan bills is no lower than 63%. This leaves him with a minimum of $40,000 to spend on an annualized basis. Here’s a summary of Steve’s financial life from year 1 (age 35) to year 10 (age 44):
When Steve enters year 11 of investing, he’s now 45. Steve is a smart guy, with almost $500k in retirement, he wants to grow his wealth. He takes the $8,788 of now free-cash-flow from his student loans and begins to contribute to a personal investment portfolio outside of his 401k. In our table, this is represented by moving the “$8,788.08” from the “Student Loan Payment” column to the “Personal Portfolio Contribution” column. He can’t contribute the $8,788 to his 401k because he’s already maxed out at the $19,000 IRS imposed contribution limit. By the age of 50 Steve achieves his life-long dream of earning $200,000 annually, where he remains until he retires at the age of 65. His net worth at the age of 65? Almost $5.5 million dollars. He has achieved the American dream of becoming a one percenter and is able to take a portion of his distribution tax free since his retirement vehicle is a roth 401k. Way to go Steve!
Option 2 — In Detail
Steve can achieve the exact same financial outcome and be debt free in 3 years instead of 10. What if instead of contributing to his 401k, he allocated the same percentage of his free cash flow to paying out his student loan debt? To achieve this, Steve will need to allocate ~$2000/month or ~$24,000 to principal + interest reduction for 36 consecutive months. Over this 36 month period, he isn’t contributing to his 401k and he’s not receiving any employer contribution. By focusing on just his student loans, he is able to pay off the loan balance in just 30% of the time and save nearly $15,000 in interest. That’s $15,000 the US Government won’t have to misappropriate!
The first 3 years for Go-getter Steve look bleak. By not contributing to his 401k, not receiving an employer match and not putting any money away for other savings/investing activities, his net worth hovers anywhere between -$66,000 and $0 dollars. Steve perseveres, at and the end of year 3 has had paid a total of $72,000 in student loan and is debt free. He is one of the elite, less than 2 out of 10 Americans are debt free.
As Steve enters year 4, debt free with over $25,000 to contribute to wealth creation, he maxes out his roth 401k by contributing $19,000 and creates a personal investment portfolio to invest the $8,788 originally earmarked for student loans. Steve achieves career success and earns a household income of $200,000 at age 50 where he remains until retirement. His net worth at the age of 65? Also almost $5.5 million dollars. Steve went against conventional wisdom, paid off his student loan early, paid less in interest to the US government and achieved the American dream of becoming a one percenter ! He receives the same benefit of taking a portion of his distribution tax free since his retirement vehicle is a roth 401k. Way to go Steve!
Steve is able to compensate for 36 missed months of not contributing to his Roth 401k by getting a 7 year head start on contributing to his personal portfolio, which, by age 65, is $1.2 millon dollars. If Steve followed option 1, his personal non-roth-401k portfolio would only have $200,000.
Putting it all together
Most of us try to multi-task and work towards retirement, wealth creation, debt elimination, vacations, and fun money all at the same time. We try to pay on our debt, save a little for emergencies, and contribute the minimum to our 401ks — all from the same paycheck. Not only does this slow our progress of completing a single goal, but it also leaves us unprepared when unexpected expenses arise. Don’t get me wrong, Just because contributing to your 401k comes after paying off debt, doesn’t mean you should take your time getting to it. You have to move fast, in less than 36 months. The more time you have to save for retirement, the more wealth you can build. So should you stop contributing to your 401k to pay off your student loan? At a minimum, the answer is not an automatic no. You shouldn’t do something just because someone, me, your best friend, your broke uncle Tom, tells you to. You need to run the calculations and decide what is the best choice. For me? I’ve stopped contributing to my 401k while I pay off $170,000 in student loan debt in less than 24 months.