You entered the workforce saddled with student loan debt. Your net worth is negative. You’re not sure how long it will take to repay your debts.
It’s no wonder you might be feeling conflicted about whether to start contributing to your IRA. How can you invest money in a retirement account when you still have large amounts of debt? Shouldn’t you pay off debt before worrying about saving?
The short answer: No. Sometimes it’s better to invest for retirement than to repay your student loans.
Contributing to an IRA
When you start working, it’s important to make the minimum payments on your student loans (at the very least) while making the maximum contribution to your retirement accounts. Contribute enough money to your 401k to take full advantage of your employer match, if applicable; after that, switch to an IRA.
Types of IRAs
Individual retirement accounts (IRAs) are tax-advantaged investing tools geared towards retirement savings. There are several types of IRAs to choose from.
Traditional individual retirement accounts (“Trad” IRAs) allow people to invest their income pre-tax, up to $5,500 for 2015 and 2016, into a tax-deferred savings account. Capital gains and dividend income grow tax-deferred.
Pre-tax contributions mean the money is deducted from your taxable income. If you earned $50,000 and contribute $2,000 to a Trad IRA, you’re taxed as if you earned $48,000. (That’s an overly-simplistic example meant for the sake of illustration; you’ll also have other tax deductions such as your standard deduction, loan interest deductions, etc.)
When investments grow “tax-deferred,” it means you don’t pay any taxes on that growth until you withdraw the money in retirement.
A Roth individual retirement account is similar to a traditional IRA. However, contributions to a Roth IRA are made with after-tax income, rather than pre-tax income.
Why would anyone want this? Because the deal is that you pay taxes once … and never again. Your capital gains and dividends don’t just grow tax-deferred, they grow tax-exempt. That means you’ll never pay a dime in taxes on that investment growth, even if it enjoys 40 years of compounding. This is known as a “tax-exempt” account.
In addition, your current tax rate might be lower than your tax rate in retirement, which means you’re taking the tax hit at a time when you’re in a lower bracket.
That’s why people in their 20s and 30s, in particular, are often attracted to Roth IRAs.
SIMPLE stands for “savings incentive match plan for employees.” SIMPLE IRA accounts are retirement plans established by employers and self-employed individuals. The employer makes a tax-deductible, matching, or nonelective contribution to each eligible employee’s SIMPLE IRA, and the employees themselves can make salary deferral contributions to their own account.
If you’re employed and your job doesn’t offer a SIMPLE IRA, you can ignore this option. (SIMPLE accounts must be set up by the employer).
If you job offers a SIMPLE IRA, you’ll want to think about whether you should make contributions to a SIMPLE IRA or your own Traditional or Roth IRA. Find out whether or not your employer offers matching contributions; if so, prioritize maxing out this match.
If your job doesn’t offer matching contributions, prioritize the account that has the taxable structure you prefer (tax-deferred or tax-exempt).
Note that contributions to your SIMPLE IRA do not preclude you from contributing to a Trad or Roth IRA. Eligible participants can max out their SIMPLE IRA in addition to maxing out their Trad or Roth IRA.
SEP stands for “simplified employee pension.”
SEPs are IRA-based retirement plans in which employers make tax-deductible contributions into the SEP accounts of eligible employees. Most contributions are made by the employer.
Employees can contribute up to $5,500 (or $6,500 if they’re 50 or older), but this is counted against eligibility for Trad or Roth IRA contributions. In other words, eligible participants can contribute a maximum of $5,500 per year (or $6,500 if you’re over 50) to a combination of Trad, Roth and SEP IRAs.
Contributing to an IRA While Paying Off Debt
Once you decide which account to fund, you’ll need to decide to tackle both student debt and funding your retirement account.
The longer you invest in your IRA or 401k, the more time you can gain interest and dividends, increasing your overall balance for retirement.
The sooner you crush your student loans, the less interest you’ll pay over time. Additionally, you’ll have excess cash every month which can go into future investments.
There are good arguments for both options (repaying loans vs. saving for retirement). You’ll need to find the right balance for you.
When you’re deciding, consider the interest rate on your loans, any employer matches, your tax bracket, and your overall comfort with both investing and debt repayment.
Roth IRA Withdrawals
Here’s an interesting twist on the retirement vs. student loans issue: Your Roth IRA contributions can be withdrawn without penalty. You could use your original Roth IRA contributions (the “principal”) to make a student loan payment.
Here’s an example: Let’s say you save $5,500 per year in your Roth IRA. At the end of five years, you’ve contributed $27,500 and these investments have grown by an additional $3,000. You hold a total of $30,500 in your account.
You can withdraw the original contribution without penalties or taxes. You’ve already paid taxes on this income, so the government won’t penalize you for tapping it early. The other $3,000 in growth needs to stay in your account, or else you’ll face penalties and taxes.
Why would you choose this option? Let’s imagine that right now, you’re equally contributing to both goals. You save $5,500 per year in your Roth IRA and put another $5,500 per year toward your student loan payments.
But let’s say that five years from now, you lose your job. It’s the middle of a recession and you’re having a tough time job-hunting. You understand that retirement is important, but your immediate goal is to become debt-free so you can lower your monthly bills. A nice $27,500 chunk of change will wipe away your debts in one fell swoop.
That’s a prime example illustrating how the flexibility of a Roth IRA can help you invest for retirement, while still preserving liquidity and flexibility.
Which Should You Choose?
Right now, you have time on your side.
The longer you allow your retirement contributions to accrue interest and dividends, the more money you’ll enjoy in retirement. You could take out a student loan, but no one will give you retirement loan. When you turn 65, you’ll need to have the funds on hand to support yourself throughout your golden years.
Don’t think of IRA contributions vs. debt payoff as an “either/or” question. Instead, embrace that you’re going to handle both. Then decide what balance you want to achieve.
If you can dedicate an extra $1,000 per month towards these goals, do you want a 50/50 split? 60/40? 70/30? Your answer depends on your interest rate, goals, and other personal factors.
At the end of the day, though, the specifics of that split are secondary. What matters most is that you’re dedicating a significant portion of your income to improving your financial life, regardless of whether that’s in the form of IRA contributions or debt payments.
Interested in refinancing student loans?Here are the top 6 lenders of 2018!
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1 Important Disclosures for Earnest.
To qualify, you must be a U.S. citizen or possess a 10-year (non-conditional) Permanent Resident Card, reside in a state Earnest lends in, and satisfy our minimum eligibility criteria. You may find more information on loan eligibility here: https://www.earnest.com/eligibility. Not all applicants will be approved for a loan, and not all applicants will qualify for the lowest rate. Approval and interest rate depend on the review of a complete application.
Earnest fixed rate loan rates range from 3.89% APR (with Auto Pay) to 5.87% APR (with Auto Pay). Variable rate loan rates range from 2.47% APR (with Auto Pay) to 5.87% APR (with Auto Pay). For variable rate loans, although the interest rate will vary after you are approved, the interest rate will never exceed 8.95% for loan terms 10 years or less. For loan terms of 10 years to 15 years, the interest rate will never exceed 9.95%. For loan terms over 15 years, the interest rate will never exceed 11.95% (the maximum rates for these loans). Earnest variable interest rate loans are based on a publicly available index, the one month London Interbank Offered Rate (LIBOR). Your rate will be calculated each month by adding a margin between 1.82% and 5.50% to the one month LIBOR. The rate will not increase more than once per month. Earnest rate ranges are current as of Month/Day/Year, and are subject to change based on market conditions and borrower eligibility.
Auto Pay discount: If you make monthly principal and interest payments by an automatic, monthly deduction from a savings or checking account, your rate will be reduced by one quarter of one percent (0.25%) for so long as you continue to make automatic, electronic monthly payments. This benefit is suspended during periods of deferment and forbearance.
The information provided on this page is updated as of 08/21/18. Earnest reserves the right to change, pause, or terminate product offerings at any time without notice. Earnest loans are originated by Earnest Operations LLC. California Finance Lender License 6054788. NMLS # 1204917. Earnest Operations LLC is located at 302 2nd Street, Suite 401N, San Francisco, CA 94107. Terms and Conditions apply. Visit https://www.earnest.com/terms-of-service, email us at firstname.lastname@example.org, or call 888-601-2801 for more information on ourstudent loan refinance product.
© 2018 Earnest LLC. All rights reserved. Earnest LLC and its subsidiaries, including Earnest Operations LLC, are not sponsored by or agencies of the United States of America.
2 Important Disclosures for Laurel Road.
Laurel Road Disclosures
Savings example: average savings calculated based on single loans refinanced from 9/2013 to 12/2017 where borrowers’ previous rates were disclosed. Assumes same loan terms for previous and refinanced loans, and payments made to maturity with no prepayments. Actual savings for individual loans vary based on loan balance, interest rates, and other factors.
Application detail: 5 minutes indicates typical time it takes to complete application with applicant information readily available. It does not include time taken to provide underwriting decision or funding of the loan.
Instant rates mean a delivery of personalized rates for those individuals who provide sufficient information to return a rate. For instant rates a soft credit pull will be conducted, which will not affect your credit score. To proceed with an application, a hard credit pull will be required, which may affect your credit score.
Total savings calculated by aggregating individual average savings across total borrower population from 9/2013 to 12/2017. Individual average savings calculation based on single loans refinanced from 9/2013 to 12/2017 where borrowers’ previous rates were provided. Assumes same loan terms for previous and refinanced loans, and payments made to maturity with no prepayments. Actual savings for individual loans vary based on loan balance, interest rates, and other factors.
3 Important Disclosures for SoFi.
4 Important Disclosures for LendKey.
Refinancing via LendKey.com is only available for applicants with qualified private education loans from an eligible institution. Loans that were used for exam preparation classes, including, but not limited to, loans for LSAT, MCAT, GMAT, and GRE preparation, are not eligible for refinancing with a lender via LendKey.com. If you currently have any of these exam preparation loans, you should not include them in an application to refinance your student loans on this website. Applicants must be either U.S. citizens or Permanent Residents in an eligible state to qualify for a loan. Certain membership requirements (including the opening of a share account and any applicable association fees in connection with membership) may apply in the event that an applicant wishes to accept a loan offer from a credit union lender. Lenders participating on LendKey.com reserve the right to modify or discontinue the products, terms, and benefits offered on this website at any time without notice. LendKey Technologies, Inc. is not affiliated with, nor does it endorse, any educational institution.
5 Important Disclosures for CommonBond.
6 Important Disclosures for Citizens Bank.
Citizens Bank Disclosures
|2.47% – 6.99%3||Undergrad & Graduate||Visit SoFi|
|2.47% – 5.87%1||Undergrad & Graduate||Visit Earnest|
|2.47% – 8.03%4||Undergrad & Graduate||Visit Lendkey|
|2.95% – 6.37%2||Undergrad & Graduate||Visit Laurel Road|
|2.48% – 6.25%5||Undergrad & Graduate||Visit CommonBond|
|2.72% – 8.32%6||Undergrad & Graduate||Visit Citizens|