Roth IRA or pay down student loan

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AlwaysAStudent
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Roth IRA or pay down student loan

Post by AlwaysAStudent »

My husband and I have approximately $4000 to decide where to allocate it to. This money is what will be left after paying taxes, it was put aside from his commissions to pay taxes. We currently have 0 retirement money saved under his name.

Background:

33M/32F - One Child (almost 2)
Gross Income: ~$65k her, $30k him (he is a realtor, we expect this to continue to go up)
Emergency Fund: $5k (my job is very stable but we do plan to increase this)
Retirement: Her 401K ($55K)
Mortgage: $130k @4.5% (30years left, just did a cash out refinance. House value ~ $180K)
Student Loans: $16k @ 7.5%
No other debt.
We do put a small amount into a 529 for the kid, we plan to increase this once the student loans are paid off and retirement is where it should be.

Options:
1) A 2015 Roth IRA under husbands name. We plan to contribute the $5500 allowed to a Roth IRA for him for 2016.
2) Pay down the student loans. We plan to have these paid off by the end of 2016 or early 2017 even if we don't utilize this $4000.

My thinking is that paying down the student loans saves us 7.5% in interest and the IRA will not make that this year. However, I also know that we need to get his retirement accounts started and we plan to pay off the student loans very quickly anyways so it may not matter.
jpelder
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Re: Roth IRA or pay down student loan

Post by jpelder »

At that interest rate, pay off the loan. There's no investment in the world that will get that kind of guaranteed return. In fact, I would only contribute up to the match in her 401k to knock out the loan by the end of the year.
climbhigh
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Re: Roth IRA or pay down student loan

Post by climbhigh »

My thinking is that paying down the student loans saves us 7.5% in interest and the IRA will not make that this year.
You are thinking in the right direction. Paying off debt will give you a guaranteed return equal to the interest rate on the debt. Check out this article for more info:

https://www.bogleheads.org/wiki/Paying_ ... _investing

With your loans at 7.5% I would recommend paying that off before you save for retirement.
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grabiner
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Re: Roth IRA or pay down student loan

Post by grabiner »

Paying off the student loan is better than contributing anything to retirement accounts, except for enough to get the 401(k) match. By paying more against the loan now, you will have more to save for retirement once the loan is gone, and you have plenty of places to put that money (her 401(k), two Roth IRAs, and a 529).
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Raiddinn
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Re: Roth IRA or pay down student loan

Post by Raiddinn »

Assuming you are contributing the minimum to retirement plans to get any employer matches, for sure pay off the student loans.

If you really want to bet on stocks, don't do it with more than half of the free cash flow that you would otherwise pay to the student loans.
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Re: Roth IRA or pay down student loan

Post by Nowizard »

Another comment: Since you stated you would pay off the loan this year whether or not you put the $4,000 in the Roth or not, you will not be paying the full interest amount unless you pay off the loan on December 31. You are, unfortunately, likely to be correct about not making 7.75% on a Roth this year. However, since you will not be distributing from the Roth for many years, you have an opportunity to purchase more shares now than when the market improves. The market is down more than 7.75% YTD which means you have theoretically "made" more than 7.75% if you consider the decrease from January 1. From that perspective, putting the money into a Roth is a better, long term decision if you are going to pay off the loan this year anyway.

Tim
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Re: Roth IRA or pay down student loan

Post by nanoanalyzer »

Have you considered refinancing the student loan? The variable rates around 2-2.5% are very attractive, especially if you plan to pay them off quickly and can respond to a rate hike with large principal payments. Almost anything would be better than 7%+.
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SouthernCPA
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Re: Roth IRA or pay down student loan

Post by SouthernCPA »

I kind of think of it differently....Sure you won't make 7.5% on the Roth This year, but you also won't get that 5,500 in roth space again (which will compound until your retirement). Unless you're on the brink and it's an "either/or" situation, I'd take the Roth contribution over the SL Paydown even if it kicked your SL payoff down the road a little bit. If you are saying you expect to have this loan paid down by end of 2016 or early 2017 even if you don't utilize the $4,000, it sounds like you're doing a great job of attacking your low debt amount.

If you can take the roth space as a 2015 contribution (before April 15), even better. Then that gives you until April 15, 2017 to make your 2016 contributions.

If the SL debt was crushing you, I'd say SL all day, but since you're going to have it paid off shortly, I'd take a 2015 Roth contribution to use up the Roth space that is "use it or lose it." Your 65 year old self will thank you.

Ballpark math: Say you pay down the Student loan by $5,500 (amount to compare vs Roth Contribution) rather than contribute to the roth. You're missing out on 30 years of tax free growth on that $5,500 to save 7.5% on the $5,500 for one year....that's $412.50 in interest but you could potentially have another $10-20k tax free in the Roth IRA in 30 years from that $5,500 space you grabbed today.

If you only compare 12 month performance of Roth to 12 month loan interest - it's easy to choose loan paydown, but when you look at how much tax free growth you are giving up by letting this years roth contribution limit "expire", it's not so cut and dry.
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grabiner
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Re: Roth IRA or pay down student loan

Post by grabiner »

SouthernCPA wrote:I kind of think of it differently....Sure you won't make 7.5% on the Roth This year, but you also won't get that 5,500 in roth space again (which will compound until your retirement). Unless you're on the brink and it's an "either/or" situation, I'd take the Roth contribution over the SL Paydown even if it kicked your SL payoff down the road a little bit.
This is only relevant if you are close to maxing out contributions, which I don't think you are. If you contribute $5500 less this year, but $5500 more next year (two Roths, or a Roth and extra contributions to the 401(k)), you won't have wasted any tax-deferred space.
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JoeJohnson
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Re: Roth IRA or pay down student loan

Post by JoeJohnson »

Nowizard wrote:Another comment: Since you stated you would pay off the loan this year whether or not you put the $4,000 in the Roth or not, you will not be paying the full interest amount unless you pay off the loan on December 31. You are, unfortunately, likely to be correct about not making 7.75% on a Roth this year. However, since you will not be distributing from the Roth for many years, you have an opportunity to purchase more shares now than when the market improves. The market is down more than 7.75% YTD which means you have theoretically "made" more than 7.75% if you consider the decrease from January 1. From that perspective, putting the money into a Roth is a better, long term decision if you are going to pay off the loan this year anyway.

Tim
And what if the market is still 10% overvalued? Buying on a 7.75% dip is nothing more than noise.
SouthernCPA
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Re: Roth IRA or pay down student loan

Post by SouthernCPA »

grabiner wrote:
SouthernCPA wrote:I kind of think of it differently....Sure you won't make 7.5% on the Roth This year, but you also won't get that 5,500 in roth space again (which will compound until your retirement). Unless you're on the brink and it's an "either/or" situation, I'd take the Roth contribution over the SL Paydown even if it kicked your SL payoff down the road a little bit.
This is only relevant if you are close to maxing out contributions, which I don't think you are. If you contribute $5500 less this year, but $5500 more next year (two Roths, or a Roth and extra contributions to the 401(k)), you won't have wasted any tax-deferred space.
I think it's still relevant - especially if OP rolls loan payments to additional Roth contributions once the loan is paid off. If OP has $16k in student loans that they can pay down by the end of 2016, that means they are putting $16k +/- toward Student loans this year WITHOUT factoring in the $4,000 windfall. It sounds like OP is doing fine toward debt pay down. This year OP has $16k budgeted paydown + $4k = $20k to apply in 2016.

OP can contribute the $5500 this year as a 2015 contribution, then use remaining $14,500 to bring SL balance to ~$2,500 by year end. Then if budget remains same, they've got another $16k next year that could pay off remaining $2,500 SL plus fund two Roth IRAs. It sounds like they'll be able to fully fund two roths next year either way if their budget remains the same (or better) so might as well get one of roths fully funded this year. Roth space is worth a bit more than extra 401k payments in my book, especially at 32 years old. This is why I said make a 2015 $5,500 contribution, then they'll be able to max two Roths for 2016 as well. That is $16,500 in Roth space over next two years, vs $11,000 in Roth space.
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Re: Roth IRA or pay down student loan

Post by rallycobra »

Refinance to a 15 yr mortgage. With 20% down and a 180k value, you have an extra 14k.

Take the 14k and pay down the student loan.

Only contribute to the IRA up to the match until the student loan is paid off.

Stop contributing to the 529. You can resume contributing after maxing the IRA and you have a larger emergency fund/taxable fund. Maybe 2 years of mortgage payments +/-?

With a 2yr old and a 15 yr mortgage, you don't really need a 529 since you won't have mortgage payments when the kiddle is in college.
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Topic Author
AlwaysAStudent
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Re: Roth IRA or pay down student loan

Post by AlwaysAStudent »

SouthernCPA wrote:I kind of think of it differently....Sure you won't make 7.5% on the Roth This year, but you also won't get that 5,500 in roth space again (which will compound until your retirement). Unless you're on the brink and it's an "either/or" situation, I'd take the Roth contribution over the SL Paydown even if it kicked your SL payoff down the road a little bit. If you are saying you expect to have this loan paid down by end of 2016 or early 2017 even if you don't utilize the $4,000, it sounds like you're doing a great job of attacking your low debt amount.

If you can take the roth space as a 2015 contribution (before April 15), even better. Then that gives you until April 15, 2017 to make your 2016 contributions.

If the SL debt was crushing you, I'd say SL all day, but since you're going to have it paid off shortly, I'd take a 2015 Roth contribution to use up the Roth space that is "use it or lose it." Your 65 year old self will thank you.

Ballpark math: Say you pay down the Student loan by $5,500 (amount to compare vs Roth Contribution) rather than contribute to the roth. You're missing out on 30 years of tax free growth on that $5,500 to save 7.5% on the $5,500 for one year....that's $412.50 in interest but you could potentially have another $10-20k tax free in the Roth IRA in 30 years from that $5,500 space you grabbed today.

If you only compare 12 month performance of Roth to 12 month loan interest - it's easy to choose loan paydown, but when you look at how much tax free growth you are giving up by letting this years roth contribution limit "expire", it's not so cut and dry.
This is DH's argument and I can admit it makes sense, especially since he just reminded me that $11k of the SL is currently not being charged interest since I am taking graduate classes.
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AlwaysAStudent
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Re: Roth IRA or pay down student loan

Post by AlwaysAStudent »

rallycobra wrote:Refinance to a 15 yr mortgage. With 20% down and a 180k value, you have an extra 14k.

Take the 14k and pay down the student loan.

Only contribute to the IRA up to the match until the student loan is paid off.

Stop contributing to the 529. You can resume contributing after maxing the IRA and you have a larger emergency fund/taxable fund. Maybe 2 years of mortgage payments +/-?

With a 2yr old and a 15 yr mortgage, you don't really need a 529 since you won't have mortgage payments when the kiddle is in college.
We just did a cash out refinance (for home upgrades) and purposely didn't include the students loans because I really did not want to be paying for them for the next 15-30 years. I think I would rather pay 7.5% for the next 18 months than 4% for 15 years.

I currently only contribute to the match on my 401k. My DH doesn't contribute anything right now.

The 529 is only getting around $600/year and most of that is from gifts so I don't think it will have a very big impact.

I do agree we need a larger emergency fund.
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AlwaysAStudent
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Re: Roth IRA or pay down student loan

Post by AlwaysAStudent »

SouthernCPA wrote: Roth space is worth a bit more than extra 401k payments in my book, especially at 32 years old. This is why I said make a 2015 $5,500 contribution, then they'll be able to max two Roths for 2016 as well. That is $16,500 in Roth space over next two years, vs $11,000 in Roth space.
I had not thought about trying to max a Roth for me in 2016 but I was planning to increase 401k once the student loans were paid off. In order to fund a 2016 Roth for me DH would need to make more that projected in 2016 or an early 2017 commission. Maybe we should focus on that before increasing my 401k. I like the decrease in taxable income from contributions to the 401k but I am guessing my future self will like the already taxed dollars later in life.
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Toons
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Re: Roth IRA or pay down student loan

Post by Toons »

Student Loans: $16

Easy Decision
Pay off debt :happy
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StormShadow
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Re: Roth IRA or pay down student loan

Post by StormShadow »

I'd try to knock down the student loan.

But if you're on the fence, then why not just split the difference? Half to loans and half to the Roth. Best of both worlds.
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bertilak
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Re: Roth IRA or pay down student loan

Post by bertilak »

Most say pay down off the loan based on the interest rate of the loan.

Although I agree, there is a counter argument. Tax advantaged space is valuable above and beyond exactly what investments are held in that space so ideally you would take advantage of that as much as possible. Any contributions you DON'T make this year can NEVER be replaced in future years.

But, an interest rate as high as 7.5% probably outweighs that. Just don't lose sight of the fact that you are giving up more than a simple difference in today's investment return vs. today's loan cost.

Of course, as others have pointed out, the employer match is a big thing to take advantage of. Don't leave money on the table. (Seems there should be a Kenny Rogers song about this.)
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Re: Roth IRA or pay down student loan

Post by JGoneRiding »

I would do both! Take the 5k emer fund and put it into a roth for dh as cash-don't buy any stock. If you have a bad enough emer you can get it out. That space is gone next year. Then put the 4k twds the loan.

See the wiki in using your roth as an emergency fund
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Re: Roth IRA or pay down student loan

Post by JupiterJones »

AlwaysAStudent wrote:Options:
1) A 2015 Roth IRA under husbands name. We plan to contribute the $5500 allowed to a Roth IRA for him for 2016.
2) Pay down the student loans. We plan to have these paid off by the end of 2016 or early 2017 even if we don't utilize this $4000.
I'd consider going with...

3) Increase emergency fund to $9,000.

Regardless of how stable your job is, there are plenty of "emergencies" that aren't job loss. If it were me, I'd make sure that I had at least three (and ideally six) months of expenses saved up before starting to invest more, pay extra on loans, etc. (Not sure what your monthly expenses are, but I'd guess that $5k isn't six months, and probably not even three months.)
Stay on target...
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Re: Roth IRA or pay down student loan

Post by CoAndy »

Personally, I would put $2,000 in your Emergency Fund, bringing that to $7,000. I would then send the other $2,000 to the student loan.
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Re: Roth IRA or pay down student loan

Post by jimb_fromATL »

We currently have 0 retirement money saved under his name.
Emergency Fund: $5k (my job is very stable but we do plan to increase this)
With so little savings I would not rush to pay off the student loans too fast.

You can kill two birds with one stone by putting the $4K in a Roth IRA. You can withdraw your contributions from a Roth at any time without tax or penalty. So it can serve as a secondary source of emergency funds. Once you have a couple of thousand dollars in more liquid savings, put up to the max per year in Roth IRAs. If you need the money for an emergency, you can take some of it back out. But if you don’t need it, you’ll be way ahead because you haven’t lost the once-per-year use-it-or-lose it opportunity to invest the money where it can earn compound interest for the rest of your life tax-free.
My thinking is that paying down the student loans saves us 7.5% in interest and the IRA will not make that this year. However, I also know that we need to get his retirement accounts started and we plan to pay off the student loans very quickly anyways so it may not matter.
IMO you shouldn’t look at the interest rate alone for just this year. That’s because Time is an exponential factor in compound interest in debts and investments that is more important than Rate in determining the total compound interest earned in an investment or paid on a debt. Because of compounding you can earn more total interest by starting to invest sooner, and you can save more interest by paying off a debt sooner. (The borrower’s debt IS the lender’s investment with interest compounded monthly on the unpaid balance.)

Your Roth will be earning compound interest for the rest of your life, whereas the student loan is a much shorter term -- with any luck at all.

For example:
  • If you owe $16,000 at 7.5% with perhaps 3 years remaining, the payment is $497.70 per month and the interest paid will be $1,917.

    If you pay the balance down by $4,000 then the $12,000 balance with the $497.70 payment will be paid off in 26.22 months with $1047 interest. So you'll save $870 interest on the loan.

    If you invest the $4000 now and earn a fairly conservative 7% average annual APY for perhaps 32 years until retirement it will grow to about $34,861 earning $30,861 interest.

    So just by missing one year of contributing to the Roth you could be giving up a potential of earning $30,861 interest for retirement in exchange for guaranteeing to save $870 on the debt.

    Time is so much more important that it doesn't really even matter if the market drops for a while. For example if you invest the $4000 now and lose 10% in the first year, then earn an average of 7% for the next 31 years, you'll still have $25,322 in earnings after 32 years. Not bad compared to saving just $870 on the loan.
In your case since you might not lose all the tax-advantage space because you’re not maxing the Roths for two already, you could conceivably come out a little better by paying off the loan.

I've never actually known anybody who once they paid off a debt immediately started reinvesting the freed-up payments. But if you had the sticktoitivity to do it, here's how it might work:
  • If you paid the $4K on the debt, then when it was paid off in 26 months you immediately started investing the freed-up payments in a Roth, the 9.8 payments of $497.70 per month earning the same 7% would be worth $4,997.

    The $4000 earning the same 7% would only be worth about $4,234, so you'd actually be a little ahead at this point because you were paying the interest on the loan to yourself instead of to the lender. But you don’t have the $4K in savings.

    That balance of 4997 earning the same 7% for the remaining 29 years 'til retirement would grow to $35,547.
So you could possibly be ahead by about $686 if you don't mind waiting until 32 years from now. And that's only IF you were not limited by the maximum yearly contributions (in other words, not planning to max out the Roths ever) and IF you truly had the resolve to religiously reinvest the freed-up payments with no delay.

However you would not have the $4000 available for emergencies during that time period. Then it would be another 8. months -- a total of 18 months from now -- before you had $4,000 in the fund for emergencies. So to me the virtual guarantee of earning a lot more interest over time by investing earlier plus the security of having the $4K in reserve makes it better NOT to use the money to pay down the debt quite so fast for such a small extra savings on the debt.

jimb
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Miriam2
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Re: Roth IRA or pay down student loan

Post by Miriam2 »

jimb_fromATL wrote:You can kill two birds with one stone by putting the $4K in a Roth IRA. . . . . . jimb
jimb_fromATL -
I'm not the OP, but I appreciate you taking the time to explain this and give your thoughts and teach the rest of us.
Also liked your descriptive word "sticktoitivity" :happy
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AlwaysAStudent
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Re: Roth IRA or pay down student loan

Post by AlwaysAStudent »

jimb_fromATL wrote:

IMO you shouldn’t look at the interest rate alone for just this year. That’s because Time is an exponential factor in compound interest in debts and investments that is more important than Rate in determining the total compound interest earned in an investment or paid on a debt. Because of compounding you can earn more total interest by starting to invest sooner, and you can save more interest by paying off a debt sooner. (The borrower’s debt IS the lender’s investment with interest compounded monthly on the unpaid balance.)

Your Roth will be earning compound interest for the rest of your life, whereas the student loan is a much shorter term -- with any luck at all.
I can follow this logic and my husband will me very happy that he didn't have to do the math to get me to agree with him. Thank you for taking the time to type that all out.
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