Pay Off Your Student Loans or Open an IRA: What Should You Do?
Paying off student loans and saving money in an individual retirement account don't always go hand in hand. If you've got a limited budget, you might have to put one goal ahead of the other.
The question is, which one should you tackle first?
The sooner you open an IRA and save for retirement, the more your money can grow over time. But, the sooner you get your student loans paid off, the sooner you can start pursuing the other big financial goals on your list.
It's not an easy decision to make when both things seem equally important. Weighing the pros and cons can give you some perspective.
If you want to open an IRA and save but you're also ready to ditch your student loan debt, here's everything you need to consider.
The Case for Funding an IRA Sooner, Rather Than Later
An IRA can be a solid way to plan your retirement future. And getting a head start on saving can pay off once you're ready to retire. The case for opening an IRA hinges on three key benefits.
1. Better return potential
So what does that mean for your long-term wealth plans? It's very simple. Investing in the market has the potential to offer a much higher rate of return over time.
The Standard & Poor 500 index, an index that measures stock market performance, delivered a 19.42 percent return in 2017 by comparison. Even if you're only earning 5% to 6% on your IRA investments, that's still significantly more growth than you'd get by parking your money in a savings account.
How does this compare to paying down your student loans? Depending on what kind of student loans you have and how much you owe, the returns on your IRA could outstrip what you're paying in interest to your loan servicer. If you're paying 5% on your loans, for example, but you could be earning 10% in an IRA, saving for retirement makes more sense financially.
2. Compounded growth
Higher returns become even more important when you factor in your timeline for saving in an IRA. Compound interest can grow your money by leaps and bounds over the long term. The longer you have to save, the longer you can benefit from earning interest on your interest.
Here's an example:
Say you put $5,000 in a Roth IRA each year, starting at age 30. If you earn a 6% annual return, you'd have over $590,000 saved by age 65. Waiting until age 35 to start saving cuts that down to $419,000. Delay until age 40 and now you're looking at $290,000, a difference of $300,000 in savings.
If you're in your 20s or 30s, time is on your side where retirement is concerned. Even small amounts can add up to big savings over time. Waiting to start can shrink your savings total and make it that much harder to catch up later.
How does this compare to paying down your student loans? Even though the money you’re putting into your retirement fund could be money that's going towards paying down your student loans, it’s important to remember that you’re getting a pretty high return on investment by putting those extra dollars in a retirement fund and racking up much bigger savings by doing so. Consider one of these budgeting apps so you can ration out your money in a way that allows you to save for that beach home in Florida but also to pay off your student debt in a timely manner.
3. Tax advantages
An IRA is a tax-advantaged retirement account. That means you get a tax break for opening and saving in one. The kind of tax break depends on which type of IRA you have.
With a traditional IRA, you may be able to deduct what you contribute each year. Whether you can deduct the full contribution depends on your filing status, income and whether you're covered by a retirement plan at work.
A Roth IRA offers a slightly different benefit. You don't get a tax deduction but you get something that could be even more valuable: tax-free withdrawals in retirement.
Both accounts have the same annual contribution limit ($5,500 for 2018). But, a traditional IRA could help you tax-wise if you're making a lot of money now and need a deduction to reduce your taxable income. A Roth IRA can help you on the back end if you're in a higher tax bracket in retirement.
How does this compare to paying down your student loans? Although you may be able to deduct up to $2,500 a year on your taxes from paid student loan interest, it’s important to weigh the pros and cons of the benefits from each tax implication. An IRA allows you to make tax-free withdrawals in retirement - which could ultimately end up saving you way more than $2,500. However, if you’re looking for a quick advantage now, the tax-deduction you may receive by paying more towards your student loans yearly, instead of contributing to your IRA, will offer money savings instantly.
Are There Any Drawbacks to Opening an IRA?
Both traditional and Roth IRAs have some downsides. You can't contribute to a Roth IRA if your income is above a certain limit, for example. And the IRS enforces certain rules about when you can use this money.
Generally, you can't withdraw money from a traditional or Roth IRA before age 59 1/2 without paying a 10 percent penalty. You'd also pay regular income tax on traditional IRA withdrawals. There are some exceptions--like using up to $10,000 to buy a first home--but if you don't have an emergency fund set aside to cover unexpected expenses, tapping an IRA could get expensive.
The Case for Paying Off Student Loans
Student loan debt affects 44 million Americans and it's proven especially burdensome for millennials, many of whom struggle to make their loan payments. Forgoing an IRA to pay off your student loans also yields three benefits.
1. Guaranteed interest savings
The interest you pay on your student loans might be low but it's still interest. Every penny you pay in interest is money you can't save or spend how you'd like.
Getting rid of your student loan debt as quickly as possible can cut down on the amount of interest you pay. That can add up to a decent chunk of savings if you've got a large loan balance.
A $30,000 balance at 5 percent, for example, would cost you $8,184 in interest, assuming a 10-year payoff. Trimming your payoff down to seven years reduces the interest paid to $5,617. That's a big motivator to wipe out your loans.
How does this compare to opening an IRA? The money you save on your interest by paying down your student loans is money that could go right into a retirement fund like an IRA. Although the sooner you start contributing to an IRA the better, you’re still helping yourself by paying down your loans and contributing what you can to your IRA, when you can.
2. Psychological relief
Student loans can be a burden on your budget but your debt can also weigh heavily on your mind. Sending money to your loan servicer month after month with no end in sight can be frustrating to say the least.
Paying off your loans frees you from that mental burden. You may feel more motivated or encouraged to set goals and take charge of your finances when student loans aren't hanging around.
How does this compare to opening an IRA? Studies show that people have a hard time thinking about the future and rather think about the present, the current, and the now. Paying off your student loans offers an immediate benefit, whereas contributing to your IRA is a long-term goal that can be hard to see the value in. It’s important that you think about the decision that serves you best; are you looking for instant gratification or a drawn-out reward that will aide you in your future?
3. Increased cash flow
Aside from saving you money on interest, paying off your student loans can put money back into your budget. The average monthly student loan payment was $393 in 2016. That's over $4,700 a year.
Think about what your budget looks like now. What could you do with an extra $393 each month? Could you save an emergency fund? Put aside money for a down payment on a home? Pay off any other debts you have?
Getting rid of your student loans gives you more freedom with your money. It can also create some much-needed breathing room in your budget.
How does this compare to opening an IRA? Freedom with your money after paying down your student debt opens the door for a lot more opportunity than you had when you were financially bound. However, contributing to your IRA is a guaranteed savings that you know you will already have if you’ve been actively contributing to it. If you decide that paying off your student debt is the number 1 priority on your list, MyBankTracker has put together some tips on how to catch up on retirement savings, once money freedom is on your horizon.
Are There Any Drawbacks to Paying Off Student Debt First?
The most obvious disadvantage of putting loans before opening an IRA is the loss of time. As the example showed earlier, waiting to save can cost you money.
Another downside to think about is the loss of the student loan interest deduction on your taxes. Once your loans are gone, you won't be able to claim this deduction. Losing a deduction could result in a bigger tax bill or a smaller refund.
What's the Smart Move?
It's a tough call but when all things are considered, paying off your student loans is the more financially sound move. Here's why.
Student loans are reported on your credit. If you lose your job or your income takes a big hit and you can't keep up with your loan payments, your credit score could take a hit. That could make it harder to get a car loan, open a credit card or buy a home.
Federal student loans usually allow you to take a deferment or forbearance during a financial hardship. These are limited, however, and at some point, you'll have to start making payments again.
Putting student loan repayment first can cut down on the possibility of ending up in a situation where your credit might suffer because you can't pay. That doesn't mean you should put saving entirely on the backburner, however.
If you're still on the fence about paying student loans or opening an IRA, these tips can help you strike the right balance between debt repayment and saving.
1. Focus on building an emergency fund first
Emergency funds are designed to help you weather life's financial storms. If you've got student loans or you're just starting out in your career, saving an emergency fund should be a priority.
Start small if you have to but commit to saving a set amount of money each payday. Schedule automatic transfers from your checking account to an online savings account, which can offer better interest rates than traditional savings accounts.
2. Snag your 401(k) match
If your job offers a 401(k) or a similar savings plan, that's an easy way to start your retirement fund without compromising your student loan debt payoff. At a minimum, you should be contributing enough into your plan to get a matching contribution if your employer offers one.
Depending on how your plan is structured, you may need to contribute anywhere from 3 to 6 percent of your paycheck to get the full match. If you don't think you can commit to that amount all at once, consider increasing your contributions by 1 percent each year.
3. Split extra money between loans and savings
If you don't want to skip out on an IRA but you don't want to defer your loan payoff, there's a way to compromise. Any extra money that comes your way can be split equally between the two.
For example, if you get a big tax refund you can send some to your loans while having part of it deposited directly into your IRA. If you budget $400 for groceries for the month but only spend $300, the extra $100 can be shared between debt and savings.
The Bottom Line
Paying off your student loans isn't always easy but seeing a zero balance on your loan statements can make you feel better about your finances. If you're putting student loan repayment first, remember to keep opening an IRA and saving in sight. Having a plan for saving once your debt is gone can help you stay on the right track.