I've given recommendations before about how you should prioritize investing versus paying down debt.  Behaviorally speaking, you're often better off paying down debt rather than investing.  Mathematically speaking, there are times when investing makes more sense than paying down low interest rate debt, even though paying off the debt provides a guaranteed return.  Deciding between maximizing out retirement accounts and paying off moderate interest debt, however, can be a conundrum.

Good Reasons To Invest in a 401k

  • Possible higher rate of return
  • Possible better asset protection (state and type of debt specific)
  • Tax advantages (deductible interest, retirement account benefits)
  • Maximizes Tax-Protected Space

Good Reasons To Pay Down Debt

  • Known, guaranteed rate of return
  • Possible better asset protection (state and type of debt specific)
  • Improved cash flow
  • Feeling of being debt free


Tax-Deferred Contribution Vs Moderate Interest Rate Debt

General concepts are fine, but sometimes you actually want to quantify the benefits of each choice.  There are a lot of variables, including unknown future returns, but if you are willing to make some reasonable assumptions about those, then quantification of the benefits can easily be done.  Consider an investor who is deciding whether to contribute to his 401K or pay off an 8% student loan.  Let's say he has $10,000 and can take either option and has a marginal tax rate of 33%.  First, let's quantify the benefit of making a 401K contribution.   There are two ways you save on taxes by doing this.  The first is that your money grows in a tax-protected manner.  Since his marginal tax rate is 33%, the reality of his 401K contribution is that 2/3 of the money in the account belongs to him and he is investing 1/3 of it for the government.  After 30 years at 8% per year, his $6667 dollars is worth $67,088.  If that money had been in a taxable account, it would have been worth at most $53,459.  So the tax-protected growth is worth $13,629.

The second way a 401K helps you save money is the arbitrage between your marginal tax rate and your effective tax rate.  This investor saved money at 33% upon contributing.  If his effective withdrawal tax rate is only 20%, the arbitrage is worth another $13,413, for a total of $27,042 more than he would have had in the taxable account.


The Comparison – 401k vs student loans

In order to compare which is the better decision, let's consider two scenarios.  In the first, he puts the $10K into the 401K this year, and pays off the debt next year . In the second, he pays off the debt this year and puts $10K, plus the $800 in interest he saved by paying off the debt, into the 401K next year.  In the first scenario, the investor reaps a benefit of $27,042 by putting the money into the 401K, and pays $800 in interest.  In the second scenario, the investor saves $800 in interest, and adds that to his $10,000 401K contribution in year 2.  29 years later, he reaps a total benefit of $26,550.  Thus, even with a similar 8% rate, making the 401K contribution is the right move, but not by much.  What if the interest rate on the debt was 12%?  Then paying down the debt comes out ahead, $27,534 to $27,042.  If the debt was at 5%, then the advantage for the 401K contributor grows to $1,229, $27042 to $25,813.  Keep in mind this is the advantage from just one year of carrying the debt and making a 401K contribution.  If you continued to make this decision each year, the benefit (or loss) would continue to compound.

Paying down debt is never a bad thing, but when the interest rate on the debt is similar to the expected return on the investment inside the 401K, you are likely to come out ahead maxing out the retirement account instead of paying down the debt.  Investing, of course, does involve taking on more risk, which should be taken into consideration.  A guaranteed return of 5-8% is nothing to sniff at.  If your debt is at 8% but you only manage 6% on the investment, the benefit of the 401K contribution is essentially eliminated ($15,053 vs $15,033).


Doesn't Matter Much

One observation I had after running all these numbers was how little it mattered.  While there is obviously a great benefit to paying off a 20% credit card, and borrowing at 1% while investing at 8% is essentially a no-brainer, it just doesn't matter all that much when you're talking about moderate interest rates.  On a sum of $10,000, it is really only a $500-1000 (per year) decision, and one year returns in the market are a crap-shoot at best.  The best option is probably to live like a resident until your student loans are gone so you can both max out your 401K AND pay off your student loans.

What do you think?  Have you had to decide between maxing out retirement accounts and paying off moderate interest debt?  How did you decide?  Comment below!