contribute to your 401k or pay off loans first? Forum

[Anonymous User]

I always thought the obvious answer was to pay down loans as fast as possible, as they represent a 6.8%+ guaranteed rate of return. then I read the following on xoxo. does this make sense?

Date: August 18th, 2012 3:53 AM
Author: Kraftwerk

Well, remember, 401(k) space is use it or lose it, and it has two valuable purposes.

1. To change the tax bracket from your high big-law one to your low retirement one. Right now you are at 28% federal + 9% state. In retirement (likely filing jointly), you should be able to get down to 15% + 6% state

2. To be able to accrue tax-free until retirement. Since you are taxed on dividends (15% + 9% - stock market pays 2.2%) and interest (28% + 9% - bond market pays 3% now, and usually much higher) each year, your yearly return will be 1% lower.

So let's assume that contributing to your 401K makes it take 5 years longer to pay off the debt.

****

OPTION 1: If you use 10,000 to pay off your debt instead of putting if in your 401(K), you will have to pay taxes on it at 28% + 9% = $6,700 left. You earn your sure 6.8% per year, and after the 5 years you'll have $9.3K.

If your investments return 8%: After 30 more years earning 7% on average, you will have $70.9K.

If your investments return 5%: After 30 more years earning 4% on average, you will have $30.2K.

*****

OPTION 2: If you put 10K in your 401(k), you won't have any taxes, so you'll start at 10K. You want to match the sure return of the debt repayment, so you can only earn 3% per year, and after the 5 years you'll have 11.6K.

If your investments return 8%: After 30 more years earning 8% on average, then paying 24% tax at the end, you will have $88.7K.

If your investments return 5%: After 30 more years earning 5% on average, then paying 24% tax at the end, you will have $38.1K.

****

So basically, you will be about 25% better off with the 401(k), regardless of the performance of the stock market, even if it delays loan repayment by a full 5 years, and even if you only earn 3% in your 401(K) during those 5 years. And if the special capital gains rate is abolished, a 401(K) will be even more important to shield accruals.

(--LinkRemoved--)

[tengorazon]

Max out the 401(k), then pay off the loans with the rest. If you're working in biglaw, you should have enough income to do both. The 401(k) deduction is one of the few that you'll have in your income bracket, and the tax-advantaged space will be very useful in retirement.

[20130312]

Absolutely max out your 401k first. Remember: in a 401(k), interest compounds. Student loans are simple interest. So you will be FAR better off in the long run contributing to the 401(k).

[ToTransferOrNot]

If you do a traditional 401k, you get an instant return on investment of about 28%--i.e., whatever your highest-dollar tax bracket is. Might even be higher than 28% depending on how your state treats 401(k) deductions. That beats the hell out of the return on paying your student loans faster.

I'm also planning to max out my stub year contributions (50% contributions for the remainer of 2012) and my 2013 contributions by May (again, 50% contributions), and then take out a 401(k) loan (50% of the balance, or about $16,000) to put into the student loans. The 401(k) interest amount is quite low, and interest payments, though not tax deductible, go into your 401(k) balance. Once you factor in your ability to take a 401(k) loan on 50% of your 401(k) balance for a marginal amount (the origination fees for a vanguard-managed 401(k) are under $100), and the 28%+ up-front tax break, you're not really taking much away from your loan payments--about 20% of the amount you contribute to the 401k, or ~$3,400 a year plus simple interest.

This breakdown doesn't work as favorably for Roth 401(k) since you don't get the up-front advantage. Since I favor immediate student loan payoff much higher than long-term retirement income, traditional 401(k) was the easy choice for me.

[tengorazon]

While we're on the subject, I'd also recommend doing a back door Roth IRA. Google it, but the gist is that people over the IRA income limit can contribute $5k to a traditional IRA, but they cannot take the tax deduction. What they can do, however, is roll over that $5k into a Roth IRA, where it will grow tax free until retirement. But you have to follow the steps in that order; you cannot contribute directly to the Roth IRA over a certain income level (around $100k I think), and there are also certain caveats if you already have a traditional IRA with gains. If you're a student or stub year, then you can probably contribute directly to the Roth IRA.

[funkyturds]

Absolutely max out your 401k first. Remember: in a 401(k), interest compounds. Student loans are simple interest. So you will be FAR better off in the long run contributing to the 401(k).

titcr.

if i had 10k:
-in 401k - can appreciate at ~5+% per year for 30 years
-pay off 10k in student loans - saves you ~7.9% in interest payments for however many years are left on the loan.

annual return is higher in the latter, but is the wrong choice long-term. (and not even considering taxes)

[BunkMoreland]

no one in this topic has thus far tried to monetize the value of feeling like you are free to quit BIGLAW whenever you want since your loans are paid off, which to me would seem to be of very high value. I'm putting every dime I can spare into my loans, even if the technical numbers work out so I should have been putting it in 401(k) - fuck that, I'd rather be done and able to leave biglaw in 2-3 years.

[tengorazon]

It's not like the money is inaccessible if you save it. You can usually take out a low-interest 401(k) loan (the interest is actually paid back into the account), or perhaps even pay the penalty if push comes to shove. It's better to focus on your overall net worth than on the outstanding loan amount.

[ToTransferOrNot]

no one in this topic has thus far tried to monetize the value of feeling like you are free to quit BIGLAW whenever you want since your loans are paid off, which to me would seem to be of very high value. I'm putting every dime I can spare into my loans, even if the technical numbers work out so I should have been putting it in 401(k) - fuck that, I'd rather be done and able to leave biglaw in 2-3 years.

Even if you do a Roth 401(k) and don't take a 401(k) loan, you're only forgoing $16.5k per year plus simple interest. So say you have a 7.3% blended rate on your loans. By forgoing the Roth 401(k) contributions, you have 17704+~19000+~20400=~$57,104 extra outstanding on your loans. $57k is a very manageable debt load on any post-biglaw salary (short of being lathamed). Doesn't seem to make sense--and this calculation is, again, ignoring the ability to take out a 401k loan and is also assuming you use a Roth 401(k) instead of a Traditional 401k--if you switch those two things up, the gap ends up being even smaller.

[ToTransferOrNot]

It's not like the money is inaccessible if you save it. You can usually take out a low-interest 401(k) loan (the interest is actually paid back into the account), or perhaps even pay the penalty if push comes to shove. It's better to focus on your overall net worth than on the outstanding loan amount.

Can't agree with this kind of unequivocol statement. Setting yourself up to pay the early withdrawl penalty--along with the likelihood that taking a distribution will force your marginal rate up for the year--is just nuts, so it really should be considered "inaccessible" as a matter of practicality. I value money I have now more than money I'll have in retirement: not in the basic time value of money sense, but in the "I could die tomorrow, more money now gives me more flexibility now and I won't care as much about flexibility when I'm old" type of sense.

[emkay625]

Does your firm match your 401K? If your firm matches your 401K contributions you should contribute up to the amount they will match. Other than that, your priorities should be as follows:

1. You need a 6 month emergency fund.
2. Pay off your student loans.
3. Retirement.

ETA: These priorities make the assumption that you will be making several big purchases in the future. You need to focus on paying off your loans in order to improve your credit score so that when you are interested in buying a car/house your interest rate is as low as possible. If you're not interested in buying either for a while, I suppose that consideration wouldn't matter.

[ToTransferOrNot]

Does your firm match your 401K? If your firm matches your 401K contributions you should contribute up to the amount they will match. Other than that, your priorities should be as follows:

1. You need a 6 month emergency fund.
2. Pay off your student loans.
3. Retirement.

How do you justify turning down an immediate highest-marginal (normally including state, not just federal, rates)-rate return? Just makes no sense. Also, the 6-month emergency fund "requirement" is flame. The only thing you're insuring against is being lathamed, and that's an awfully pricey investment to make (at what amounts to a 0% RoR) for a very low chance occurence.

[emkay625]

Does your firm match your 401K? If your firm matches your 401K contributions you should contribute up to the amount they will match. Other than that, your priorities should be as follows:

1. You need a 6 month emergency fund.
2. Pay off your student loans.
3. Retirement.

How do you justify turning down an immediate highest-marginal (normally including state, not just federal, rates)-rate return? Just makes no sense. Also, the 6-month emergency fund "requirement" is flame. The only thing you're insuring against is being lathamed, and that's an awfully pricey investment to make (at what amounts to a 0% RoR) for a very low chance occurence.

I'd much rather be safe than sorry.

[tengorazon]

It's not like the money is inaccessible if you save it. You can usually take out a low-interest 401(k) loan (the interest is actually paid back into the account), or perhaps even pay the penalty if push comes to shove. It's better to focus on your overall net worth than on the outstanding loan amount.

Can't agree with this kind of unequivocol statement. Setting yourself up to pay the early withdrawl penalty--along with the likelihood that taking a distribution will force your marginal rate up for the year--is just nuts, so it really should be considered "inaccessible" as a matter of practicality. I value money I have now more than money I'll have in retirement: not in the basic time value of money sense, but in the "I could die tomorrow, more money now gives me more flexibility now and I won't care as much about flexibility when I'm old" type of sense.

Of course your 401(k) should be raided as a last resort (hopefully the OP will have savings in addition to the 401(k)...$17k/year is not enough), but that doesn't change the fact that it's there if you really, truly need it. On the other hand, if you pay down your loans, you can't ask for the money back in an emergency.

I don't see the point of your last sentence. I assume you're saving for retirement despite valuing "more flexibility now." Everyone has to strike a balance.

[tengorazon]

Does your firm match your 401K? If your firm matches your 401K contributions you should contribute up to the amount they will match. Other than that, your priorities should be as follows:

1. You need a 6 month emergency fund.
2. Pay off your student loans.
3. Retirement.

How do you justify turning down an immediate highest-marginal (normally including state, not just federal, rates)-rate return? Just makes no sense. Also, the 6-month emergency fund "requirement" is flame. The only thing you're insuring against is being lathamed, and that's an awfully pricey investment to make (at what amounts to a 0% RoR) for a very low chance occurence.

I'd much rather be safe than sorry.

You two are talking about two different situations. If you're going to plow everything you can into student loans, then yes, you should have some sort of "emergency fund." On the other hand, if you're saving lots of money in a 401(k), Roth IRA, and taxable investments, then an additional 6 months of cash is overkill.

[franklinlincoln]

I always thought the obvious answer was to pay down loans as fast as possible, as they represent a 6.8%+ guaranteed rate of return. then I read the following on xoxo. does this make sense?

Date: August 18th, 2012 3:53 AM
Author: Kraftwerk

Well, remember, 401(k) space is use it or lose it, and it has two valuable purposes.

1. To change the tax bracket from your high big-law one to your low retirement one. Right now you are at 28% federal + 9% state. In retirement (likely filing jointly), you should be able to get down to 15% + 6% state

2. To be able to accrue tax-free until retirement. Since you are taxed on dividends (15% + 9% - stock market pays 2.2%) and interest (28% + 9% - bond market pays 3% now, and usually much higher) each year, your yearly return will be 1% lower.

So let's assume that contributing to your 401K makes it take 5 years longer to pay off the debt.

****

OPTION 1: If you use 10,000 to pay off your debt instead of putting if in your 401(K), you will have to pay taxes on it at 28% + 9% = $6,700 left. You earn your sure 6.8% per year, and after the 5 years you'll have $9.3K.

If your investments return 8%: After 30 more years earning 7% on average, you will have $70.9K.

If your investments return 5%: After 30 more years earning 4% on average, you will have $30.2K.

*****

OPTION 2: If you put 10K in your 401(k), you won't have any taxes, so you'll start at 10K. You want to match the sure return of the debt repayment, so you can only earn 3% per year, and after the 5 years you'll have 11.6K.

If your investments return 8%: After 30 more years earning 8% on average, then paying 24% tax at the end, you will have $88.7K.

If your investments return 5%: After 30 more years earning 5% on average, then paying 24% tax at the end, you will have $38.1K.

****

So basically, you will be about 25% better off with the 401(k), regardless of the performance of the stock market, even if it delays loan repayment by a full 5 years, and even if you only earn 3% in your 401(K) during those 5 years. And if the special capital gains rate is abolished, a 401(K) will be even more important to shield accruals.

(--LinkRemoved--)

Totally depends on if you're married. Marginal tax rate makes the difference.

[Anonymous User]

Are there some good websites to help build some knowledge on the subject of personal finances? I always figured I would go to a financial adviser once I started with my firm, but maybe I can learn a thing or two during 3LOL year. Some info that might help point me in the right direction: married and hopefully starting a family in a couple years, will graduate with ~60k in debt from law school (no other debt), looking to buy a house a year or so after starting at the firm (decent down payment already saved up from working prior to ls), market paying firm job in the SE, SO will work (teacher) until we start a family. Thanks for any suggestions.

[tengorazon]

Are there some good websites to help build some knowledge on the subject of personal finances? I always figured I would go to a financial adviser once I started with my firm, but maybe I can learn a thing or two during 3LOL year. Some info that might help point me in the right direction: married and hopefully starting a family in a couple years, will graduate with ~60k in debt from law school (no other debt), looking to buy a house a year or so after starting at the firm (decent down payment already saved up from working prior to ls), market paying firm job in the SE, SO will work (teacher) until we start a family. Thanks for any suggestions.

Financial advisors are a waste of time and money. They'll charge you out your ass (including signing you up for expensive funds with hidden fees or churning stocks for commissions) and will almost certainly underperform a simple portfolio of carefully selected, low-cost index funds.

Go to Bogleheads and browse around (you should especially read the first two threads at the top): http://www.bogleheads.org/forum/viewforum.php?f=1

Also take a look at their wiki: http://www.bogleheads.org/wiki/Main_Page

It's quite easy to manage your own investments.

[ben4847]

401k

[dingbat]

Does your firm match your 401K? If your firm matches your 401K contributions you should contribute up to the amount they will match. Other than that, your priorities should be as follows:

1. You need a 6 month emergency fund.
2. Pay off your student loans.
3. Retirement.

In a thread full of fail, this is the only good response.

Put simply: currently, it is highly unlikely that your investments will outperform the cost of your student loans on a tax adjustable basis.
If you're borrowing at 6.8%-7.8% and "only" netting 4%-6% on your investments, even with all the tax advantages of a 401(k), it's a losing proposition.

When interest rates and investment returns go up, this will probably no longer be the case, but, in today's economy, you should max out your student loan repayments (but make sure you receive any matching contributions; that's almost always worth it)

edit: the email quoted by OP is full of fail.
1) nice rosy estimate at 8% high. I know some hedge fund managers who are jealous...
The 5% is a more likely scenario, but a lower rate scenario should be shown as well - to describe the risks

2) any piece of advice that says the following (and is not describing an uncorrelated asset) should raise serious red flags:

regardless of the performance of the stock market

3) according to the author's calculations, you're barely better off at 5%, but the author has the audacity to say you'll be better off even at 3%

4) the author ignores the fact that many people (particularly those in high-paying jobs) actually have high incomes after they retire and are still in a high tax bracket. Anyone familiar with a Roth IRA should understand that the entire reason Roth IRAs exist is because that is quite common

[Anonymous User]

Are there some good websites to help build some knowledge on the subject of personal finances? I always figured I would go to a financial adviser once I started with my firm, but maybe I can learn a thing or two during 3LOL year. Some info that might help point me in the right direction: married and hopefully starting a family in a couple years, will graduate with ~60k in debt from law school (no other debt), looking to buy a house a year or so after starting at the firm (decent down payment already saved up from working prior to ls), market paying firm job in the SE, SO will work (teacher) until we start a family. Thanks for any suggestions.

Financial advisors are a waste of time and money. They'll charge you out your ass (including signing you up for expensive funds with hidden fees or churning stocks for commissions) and will almost certainly underperform a simple portfolio of carefully selected, low-cost index funds.

Go to Bogleheads and browse around (you should especially read the first two threads at the top): http://www.bogleheads.org/forum/viewforum.php?f=1

Also take a look at their wiki: http://www.bogleheads.org/wiki/Main_Page

It's quite easy to manage your own investments.

Thanks. I think Ill buy a couple of the suggested books in that link. Any other good books not mentioned in that first sticky aimed toward beginners?

[ToTransferOrNot]

Does your firm match your 401K? If your firm matches your 401K contributions you should contribute up to the amount they will match. Other than that, your priorities should be as follows:

1. You need a 6 month emergency fund.
2. Pay off your student loans.
3. Retirement.

In a thread full of fail, this is the only good response.

Put simply: currently, it is highly unlikely that your investments will outperform the cost of your student loans on a tax adjustable basis.
If you're borrowing at 6.8%-7.8% and "only" netting 4%-6% on your investments, even with all the tax advantages of a 401(k), it's a losing proposition.

I don't understand how that is the case. A biglaw attorney gets an instant 25%+ "return on investment" from the tax savings (when you're talking about a traditional 401k). Even if you net 0% on your investments during the time your student loans are oustanding, payments into the student loans (instead of the 401k) would still take 3+ years to balance out the return from the tax savings. And that ignores 401(k) loans.

[dingbat]

I don't understand how that is the case. A biglaw attorney gets an instant 25%+ "return on investment" from the tax savings (when you're talking about a traditional 401k). Even if you net 0% on your investments during the time your student loans are oustanding, payments into the student loans (instead of the 401k) would still take 3+ years to balance out the return from the tax savings. And that ignores 401(k) loans.

You're forgetting that you will need to pay tax when the money comes out of the 401(k)*

Put simply, imagine someone giving you money, but saying you must give me 1/4
The person will give you a choice: you can take $10 now, and whatever your share is, he'll invest at 20% for a year OR the person will give you $12 next year (it was invested at 20%)

Either way, you end up at exactly the same place: $9 (the difference is, either I get $2.50 today, or $3 next year)

*the key factor is, you know what your tax rate is today, but god knows what your tax rate is when you take the money out

[20130312]

dingbat, my 401(k) has made 9% this year. jelly?

Also, as I said earlier, the money you put in a 401(k) will compound interest for decades, whereas the 6.8%-7.8% that you pay on a loan 1) doesn't compound and 2) only lasts for as long as the loan exists (maximum of 25 years thanks to my main man Obama). In the long run, you're far better off investing in the 401(k). Obviously, having some liquid savings built up is recommended for emergencies, and you should still put as much as you can toward your student loans, but if you're in biglaw there's no excuse to not max out your 401(k) contribution.

Your analysis also depends heavily on the uncertainty of future tax rates, which IMO shouldn't be considered since it's so unpredictable. You'd have to pay the taxes today if you didn't invest in a 401(k).

[dingbat]

dingbat, my 401(k) has made 9% this year. jelly?

congratulations

edit: in that case the 401k is absolutely the better option