IRA vs Student Loans

IRA vs Student Loans
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#1

Hello! I’m currently 29 years old and still paying on student loans. I have a 6 total loans. Here are the balances and interest rates sorted by interest rate:

  • $6,478 @ 9.125%
  • $14,653 @ 6.625%
  • $4,692 @ 6.55%
  • $2,157 @ 6.55%
  • $614 @ 4.25%
  • $2,622 @ 3.15%

I’m currently meeting the federal limit on 401k contributions ($19k/year). I have some money (about 7k, maybe more) I was starting to invest with but have decided I want to put it into my loans or into an IRA. I’m trying to figure out if it’s better to pay off my higher rate loans or take that money and put it towards the tax deductible limit of an IRA and then putting the rest into loans.

My view is the way the money would compound until I retire would equate for more than I’d save on interest and it would help my tax refund which could be put into loans as well. Is this correct? If no, please explain why.

Thanks for the help!


#2

Hi Anthony!

Welcome to the NW Community, and thanks for sharing your loan details – that’s important context that will help us give you the best answer.

It’s awesome that you’re already contributing the maximum amount to your 401(k). At your age, that’s a huge accomplishment. I don’t believe there’s a right or wrong answer to your question – investing more in retirement and paying down high-interest student debt are both legitimate and important goals.

On average, you can expect a 6% rate of return on a Roth IRA. But as you mention, the power of compound interest means that if you invested $5,500 today (the maximum contribution amount for 2018, and you can make 2018 contributions until 4/15/19), you’d have $47,447 at age 65, according to our compound interest calculator.

However, some people would say that since one of your student loans has a 9% interest rate — more than you can expect to earn through the Roth IRA — you should use your extra $7,000 to wipe out that 9% interest loan. That could be a huge weight off your shoulders mentally, too.

Maybe the solution is a compromise: Start an IRA with a small amount of money, and make a large, lump-sum payment on that high-interest student loan. As you pay down more of your student loans, increase the IRA contribution.

I hope this helps!
Teddy

P.S. You could also consider refinancing some or all of your student loans to get those interest rates down. (There are a lot of other considerations to take into account before refinancing, though: You’ll lose federal loan benefits if you refinance federal student loans, and you need excellent credit to qualify for the lowest rates).


#3

Hi Anthony,

Teddy gave you some great advice. I’d add a couple notes:

The long-term return on the investments in your IRA is going to depend on those investments themselves — the way you’ve chosen to split your money between stocks and bonds — so be sure to be realistic about what you can expect and compare that to the interest rates on your student loans.

And since you mentioned the tax benefits associated with an IRA: It sounds like you’re interested in an immediate tax deduction, which would come from a traditional IRA, not a Roth. However, make sure you familiarize yourself with the rules around deducting traditional IRA contributions if you also have a 401(k). If you exceed the income for deducting your contributions, you might still be within the income range to qualify for a Roth IRA. (Those are listed in the same post linked above). And if you don’t qualify for either, there are benefits to a nondeductible IRA and taxable investment accounts.


#4

Echoing what Arielle said: If you’re single, your ability to deduct an IRA contribute starts to phase out when your modified adjusted gross income in 2019 exceeds $64,000 and goes away at $74,000. Since you’re already maxing out your 401(k), I’m guessing your MAGI might exceed those limits–or maybe you’re just a really good saver!

I’m a huge fan of taking advantage of compounded returns early and often. But it’s also important to have a decent emergency fund (at least three months’ worth of expenses–I prefer six months’ worth) and to pay off higher-rate debt.

Hope we gave you the answers you were looking for–please let us know!


#5

Thanks for the responses! I did not realize the IRA contribution limits were so low! I believe for tax year 2018 we would meet the full deduction limits but I don’t think we will be for 2019. Maybe it’s a good idea to take advantage of the tax benefit for 2018 while I know I’m eligible then start working down those loans as much as possible. Thanks for the insight!


#6

I don’t think that’s a bad plan, especially if your primary goal is to reduce your taxes right now. It sounds like next year, you might be above the limit for deducting traditional IRA contributions but within the limits for contributing to a Roth IRA. It’s a good idea to take advantage of a Roth IRA at that point — assuming you have a traditional 401(k), you’re building a big pot of pre-tax money for retirement. I always think it’s a good idea to balance that out with a Roth IRA. Because Roth IRAs are after-tax, you’ll be able to pull money out without income taxes in retirement. That means you’ll have some tax diversification — the pre-tax money in the 401(k) and after-tax money in a Roth.


#7

What are the benefits of federal school loans?


#8

Hi Julie,

Welcome to the NerdWallet community!

Federal student loans have several benefits that private student loans don’t have. This article has more details, but in general, federal loans:

  • Are sometimes subsidized, which means that you won’t have to pay the interest that accrues while you’re in school and during other periods of deferment.

  • Are eligible for various repayment plans including income-driven plans, which limit monthly payments to a percentage of your income. Payments can be as low as $0/month if your income is low enough.

  • Can be eligible for loan forgiveness through income-driven repayment, Public Service Loan Forgiveness or Teacher Loan Forgiveness.

We may be able to give you a better answer if you share more details about your situation. Are you trying to decide whether you should contribute to an IRA or pay down student debt?

Best,
Teddy