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.
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