Good news for young workers with college loan debt.
Uncle Sam recently approved an unnamed employer’s plan to offer a student-loan benefit program under which it would make special 401(k) contributions into the accounts of employees who are making student loan repayments. Read IRS Allows 401(k) Match for Student Loan Repayments and Private Letter Ruling.
The bad news? Not all employers offer this kind of employee benefit. And that means most young workers who are saddled with student loans (which totaled $1.41 trillion as of June 30) must decide whether to save for retirement and pay down their debt, or pay down their debt first and then save for retirement, or pay down as little debt as possible and save as much as possible for retirement.
What say experts?
It is no secret that the student loan responsibility has increased considerably in recent decades, says Autumn Campbell, a certified financial planner with The Planning Center.
Meanwhile, retirement funding responsibility, she says, has also shifted from pensions to 401(k)s, reducing the employer responsibility and placing it on the shoulders of employees.
“With opportunity comes responsibility,” says Campbell. “It is common for young workers to find themselves caught between the decision to pay off debt and to save for retirement.”
What’s the Match?
While there is no catch-all answer, she says there are things to to consider when deciding how to allocate dollars for debt and dollars for retirement. “Generally, we first look into what employer matches are available,” she says. “Of employers that match contributions, usually there is a 50-100% match on the first few percentages of income put into the retirement plan. A 50-100% guaranteed instant return — pending the vesting schedule — is likely higher than anything else available, so we take advantage of that first.”
Beyond that, Campbell says the conversation becomes more nuanced, as interest rates, balances owed, and risk tolerance comes into play. “For those that are risk averse and also uncomfortable with debt, paying off student loans may be the best route to go, especially if those loans are a high interest rate,” she says. “Paying down student loans has interest rate ‘savings’, if you will, of any amount of principal paid down. The certainty of interest savings that would have otherwise accrued — another way of measuring ‘return’ — can be really motivating behaviorally for those particularly concerned about items on the debt side of the net worth ledger and those who find discomfort in market uncertainty while holding on to debt.”
As student loans are paid off, Campbell says cash flow flexibility increases, not to mention the behavioral “wins” we feel when those financial weights are lifted off the ledger.
Another Viewpoint: What’s the Interest Rate?
When it comes to deciding on saving for retirement versus paying down debt, Eric Roberge, a certified financial planner with Beyond Your Hammock, says it’s important to examine the interest rate first. “Is the rate above 5%?” he asks. “Is it variable? If either answer is yes, there is more of a reason to pay down the debt quickly, even if that means reducing your retirement contributions.”
He would not, however, reduce the retirement contributions below the contribution needed to receive the full matching contribution of the employer. “That’s free money, which trumps the interest rate on the debt,” he says.
To be fair, just like any other financial planning topic, there are many gray areas, says Roberge. For instance, what if the student debt is a fixed-rate loan less than 5%? “I still think you need to contribute enough to the 401(k) to get the employer match, but depending on the urgency of your other goals, it may be worth paying off the loans with any extra cash,” he says. “Once your loans are paid off, you will have more flexibility with your cash flow, and therefore can save for other important goals like starting a business, buying a home, and the like.”
Use Geometric Thinking
For his part, Kerry Uffman, the owner of TWRU Private Wealth Management, says he has a hard time not saying “hell, no” to paying off debt first and then saving. “I can think of circumstances where paying off debt first might be best, but it would be limited to paying off debts that are like credit card debt with crazy high interest rates or debts established where someone is living artificially beyond the means,” he says.
But in the more hopeful common scenario, Uffman says, that would assume student debts were created to leverage a prosperous future career. “The best advice should be save first, then pay off debt,” he says. “Unfortunately, this is not the typical ‘smart’ advice.”
Why? The “payoff debt first, save later” advice is, says Uffman, anchored by what can be called “linear thinking, whereby financial problems are resolved using false logical processes that do not recognize financial problems need to be solved by geometric thinking.”
Geometric thinking, he says, recognizes time impacts money growth progressions. “Linear thinking is anchored by nearby observations of how unexciting money grows over the first six or seven years,” says Uffman. “Linear thinking is shaped by this experience of observing savings growth these first few years of a career. Unfortunately, solving financial problems based on experience of the early years of career, will cause a significant damage to your financial good over time.”
Uffman further says paying off debt first uses a linear yard stick as if money’s growth progressions are somewhat flat if observed when graphed, creating the illusion that wealth grows slowly in non-exciting way. “So, why not pay off debt first if money grows slowly?” he asked. “That’s the false illusion because wealth grows sharply — not slowly — but generally after about seven years. So linear thinking individuals might say: ‘Well, I’ll start saving about then.'”
Here’s the problem with that says Uffman. “There’s a huge cost in waiting to save,” he says. “A young person just needs to compare the two competing strategies in terms of their financial position in terms of accumulated wealth versus debt levels at these three milestone dates: seven years out, 10 years out and 15 years out. What they will likely observe is the money that they don’t use to pay off debt that is left to be saved to grow geometrically, will begin to rise almost like a jet taking off around year seven, then begin a steep upward climb from that point on. That’s how annual savings grows.”
Paying off debt first, he says, just delays when this progression can begin. “A delay with a shorter runway of time over a working career,” says Uffman. “Thus, there is huge cost to waiting to save. Actually through using geometric thinking, you find after about 15 years, that’s when to get out of student debt. At this point the saving growth curve is very steep, so debt pay down will not dampen the wealth curve rise as much.”
Finally, he says, there is a reason for the “cash is king” maxim. “For a young person, leaving oneself with no cash and no debt because of the rush to pay off student debt, is a much vulnerable situation if one lost a job for example,” he says. “When you have cash, you can weather obstacles much better even with the student debt still in tow.”
Another cost of waiting, he says, is not funding as fast as possible a Roth IRA or Roth 401(k) account. “This a gift from the boomers to the younger generations,” says Uffman. “But it’s a gift you only get to enjoy if you save as much you can within the Roth ‘tax-free-forever’ environment.”
For her part, Campbell agrees that retirement savings is important, especially in the early years so compound returns can magnify. “In the early earning years, I tend to recommend Roth IRA to clients if we assume their income will be higher in later years so we lock in lower tax rates on those dollars saved,” she says.
In addition, Campbell says Roth IRAs have more flexible withdrawals rules prior to age 59 1/2 under qualified circumstances that pre-tax qualified plans do not offer.
The Newest Employee Benefit
As for employers that offer 401(k) matches for student loan repayment, Campbell had nothing but praise. “(Those employers) are being proactive in supporting their workers with some of the most common situations and creating innovative solutions to assist,” she says. “Many young workers are faced with the question of paying down debt or saving for retirement. Employers that have begun to give 401(k) matching contributions for student loan repayments are allowing the answer to be ‘why not both?'”
According to Campbell, the notion that plans can now make special 401(k) contributions into the accounts of employees who are making student loan repayments will open up a whole new incentivized way to save for the future. “This is certainly an innovative way to tackle some of the leading questions and concerns of today’s workforce,” she says. “Employers that tout a benefit such as this are undoubtedly getting a competitive edge in the marketplace. Employees can now have a choice to save toward debt or toward 401(k) contributions and get a match from their employer either way — sounds like a win for everyone.”
Roberge also thinks the IRS ruling that would allow this company to contribute to employees 401(k) plans as long as they are paying down debt could be an excellent idea. “Many young clients are much more interested in paying off the debt than they are in saving for retirement, so this would seem to support that momentum rather than continue to fight against it,” he says. “Young people are bothered by the fact that the loan repayment amount reduces their cash flow significantly, which reduces their ability to fund other goals like travel, buying a home, starting a family, etc. Since these goals are much more short term and real to them, they often win out over saving for the distant future.”
This ruling, says Roberge, would provide a new motivation to pay off the student debt, since they’d also get the benefit of an increased retirement account balance. “There are quite a few logistical areas to contend with, such as ERISA rules, but from the big picture, this looks promising,” he says.
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