Paying off debt quickly is a great idea, but for big savers, paying off debt so aggressively that you neglect retirement saving could leave you with a smaller nest egg when you retire.
The conventional wisdom
On its surface, the choice between paying off debt and investing for retirement is a simple one:
- Debt often comes with higher interest rates than you could consistently get from your investments
- Because you have to pay taxes on investment gains and the interest on most debts is not tax-deductible, your investment rate of return has to be even higher for it to become the better choice (Nb. Some of your student loan interest may be tax-deductible depending on your income)
- The interest rate on student loans is guaranteed; few investments out there can make the same claim
And for these as well as other important but intangible reasons, the right answer for most people is to prioritize debt-payoff over investing for retirement.
The big savers
The numbers get muddled when it comes to a small subset of the population — those people who, through a combination of earning and not spending, have more than $23,000 left over at the end of the year for retirements savings or paying off debt.
You could call folks in this group the big savers.
Being a big saver is great! Cutting down my spending enough to send tens of thousands of dollars toward retirement savings or debt payoff every year has been an important part of seeing my net worth jump in value very quickly!
But there’s one thing that’s not so great for big savers: sooner or later you’re gonna have to put some of that big savings into a taxable account instead of a tax-advantaged account like an IRA or a 401(k) because the total you could contribute to these for the 2014 tax year was $23,000 — $5,500 for the IRA and $17,500 for the 401(k).
(Note that it’s definitely still a good thing to put money into a taxable account; just not as great as putting it into a tax-advantaged account. Also note that the 401(k) limit has gone up to $18,000 for the 2015 tax year, but I don’t feel like changing my math.)
Could slower debt payoff make sense for big savers?
One way to avoid hitting 401(k) and IRA caps is to spread the money I send toward these accounts across as many years as possible.
And one way to spread money to retirement accounts across as many years as possible is by never focusing so aggressively on debt that you don’t contribute up to those caps.
It may make sense to show this as an example.
Suppose a big saver har a starting loan balance of $120,000, with an interest rate of 7%.
Suppose further that after taxes, she has $40,000 left over each year to either pay off this debt or to invest with a long-term rate of return of 7% — with up to $23,000 of that able to go into a 401(k) or IRA. For the sake of simplicity, let’s assume that she chooses the Roth version of both the 401(k) and IRA.
Finally, suppose that investment returns made outside of a tax-advantaged account would be hit with a capital gains tax rate of 15%.
Scenario 1: Debt-focused pay-off
In this scenario, the big saver forgoes any retirement savings and sends every last penny of that $40,000 toward her student loans until they’re paid off entirely in the fourth year. Here are her payments for the first ten years:
An aggressive debt pay-off like this means she would pay $9,000 in interest over the life of the loan — not great, but less bad than it could get.
In this scenario, she wouldn’t start saving for retirement until 2018, but would put every penny toward it from then on. At the end of the ten-year period in 2024, she would have a tax-advantaged savings balance of $204,000 and a taxable savings balance of $137,000 — a total of $341,000.
Even without adding anything else to these accounts, if she were to then let that $341,000 sit for another twenty years until she was ready to retire, she’d be left with a cool $1,225,000 to live out her days. Not bad!
Scenario 2: Tax-advantaged retirement-focused pay-off
In an alternate scenario, the big saver could instead focus on contributing all the way up to the $23,000 retirement maximum right off the bat, and then send whatever’s left over of the $40,000 toward paying down her debt. Here are her payments for the first ten years:
In this scenario, she would split her money between retirement savings and debt pay-off in every one of the first ten years. Doing this, she would need all ten years to pay off her debt and would pay a whopping $56,000 in interest over that span. However, her retirement savings would look very different at the end of those ten years:
At the end of the ten-year period, she would have a tax-advantaged savings balance of $320,000 and a taxable savings balance of $15,000 — a total of $335,000. Note that this is a little bit less than the $341,000 total she ended up with after ten years in the last scenario.
However, because much of it is in tax-advantaged accounts, if she were to let that $335,000 sit for another twenty years until she was ready to retire, she’d be left with $1,288,000 to live out her days. That’s $65,000 more than when she focused on her debt first!
Moreover, this result holds even the rate of return on investments is slightly lower than the interest rate on the loans — down to 4% in this case. It’s only when the average long-term rate of return on our investments goes down to 3% that focusing first on debt pay-off becomes the more profitable option.
Want to play with the model yourself? Spreadsheet is right here:
For a very narrow subset of the population who can save enough to exhaust all the available tax-advantaged retirement options every year, they can end up with more money at retirement by not focusing aggressively on their debt and instead focusing on their retirement savings.
And all that said, does this mean that I’m going to stop paying down my debt so aggressively?