Paying off student loan aggressively versus maxing out 401k?

 

My friend M. asked me following question: "Initially we were going to pay off the student loans aggressively and be done in 12-14 months. Now we are considering maxing out both 401ks to get the tax benefit. What makes more sense?"
 
 
The question is about prioritizing. Prioritizing maxing out 401k versus paying off loans.
But there are few more things which are in the priority list.
Usually after finishing residency most physicians have following major items where a lot of money has to go:

Loans
Student loan
House mortgage
Car payments
Insurances
Term life insurance
Disability insurance
Car/home/liability insurance
Savings
Health savings account
Savings for retirement
 
 
How to prioritize them?
 
One way is to prioritize by risk/consequences.
 
Prioritizing by risk means to prioritize by the most detrimental impact which have to be taken care off first. For example, if the breadwinner of the family dies, his/hers income should be replaced in some way.
 
The insurances can be grouped together and should be taken care of first:
 
1. Disability - will cover lost income.
2. Term life - will pay out a certain sum of money to cover lost provider, is necessary is the loss of provider will be financially very hard on spouse and/or child.
3. Car/home/liability insurances - helps with large assets in the worst case scenario if they need to be replaced, liability gives additional protection in case of unintentional harm to others.
 
After you are done with that, you can move to the group of Savings and Paying off loans:

1. Health savings account - for current or future disease related expenses.
2. Savings for retirement 401k, Roth IRA - if prioritizing by risk, tax-deferred accounts should be put before paying off mortgage because there is a better protection for retirement accounts in case of a bankruptcy - you get to keep your pension and retirement plan funds. In Tennessee tax-exempt retirement accounts, including 401(k) are protected. Roth IRA is protected up to $1,283,025 as of 2018. (This amount is adjusted every three years. For detailed information for your state go to NOLO.com.)
3. Car payment, house mortgage and student loan - I would group them together especially if they have similar low interest rates. They are not as well protected as retirement accounts.
 
 
But what if you say: Yes, prioritizing by risk is all good, but I personally think that the bankruptcy risk is very low for me. Maybe it will be better for me to pay off the student loans or mortgage first, before maxing out 401k and Roth IRA?
 
 
I already wrote about the difference of paying off the mortgage early versus investing the money that was used for the extra principal payments. Investing comes out ahead.

With current interest rates, it makes more sense financially to invest instead of paying off the mortgage early. If your interest on student loan is in the same ball park as the current mortgage rates, that would have the same effect. And by investing in a tax-deferred account like 401k, you will also receive tax savings. 


How much tax savings can you get?
 
If you contribute maximum ($18,500 for 2018) to the pre-tax 401k, you will save $5,920 in 32% tax bracket and $6,475 in 35% bracket. This is a significant amount which can be put into Roth IRA ($5,500 in 2018, see my post on how to use the back-door Roth IRA).

In 2018 most physicians will be in the 32% or 35% bracket.
If both spouses are maxing out their 401k, the tax savings are doubling and will be $11,840 in 32% bracket and $12,950 in 35% bracket, which is enough for maxing out both Roth IRAs.
You will not get those tax savings if you choose to contribute to Roth-401k (see here why I don't do Roth401k).
 


If you are 45 years old now and will make yearly contributions of $18,500 to your 401k, then at the age of 65 with 6% yearly growth and 3% inflation the balance will be $700,949. The number is of course approximate because returns will vary.
 
If you decide to pay off your student loans first, you will have less years left to contribute before tax. Dependent on how many years you will have left to contribute, you will forgo on:

19 years left:
401k balance at age 65: $643,297
Difference in total savings balance at age 65: $57,652
Lost tax savings, 1 year: $5,920
 
18 years left:
401k balance at age 65: $588,907
Difference in total savings balance at age 65: $112,042
Lost tax savings, 2 years: $11,840


But that is not all.

The employers contributions were not taken in account yet.

How much employers contribute is variable. The total maximum on total contributions (employee plus employer) is $55,000 in 2018 (or 100% of your salary, whichever is less).
This means that your employer could contribute up to $36,500 in 2018. 


In summary, if you compare paying off a low interest loan like a mortgage or a low interest student loan, versus investing in a taxed account, you will come out ahead with investing.

If you compare paying off a loan versus contributing to a tax-advantaged account like pre-tax 401k, you will not only come out ahead with investing but also have your savings grow fax free, you will save on taxes and you will get employer's contributions.