How to Pay Student Loans To Maximize Your Wealth - Distilled Dollar

How to Pay Student Loan Debt To Maximize Your Wealth

Student loan debt in America grows by $2,726 every second.*

Luckily for some, companies are beginning to embrace programs to help recent grads pay down their debt. One such platform offered to employers was created by Student Loan Genius.** The program can match an employee’s student loan payments by contributing to their 401(k).

I wish every company had such a benefit.

But what many millennials don’t realize is that you don’t need the right employer offering such a benefit because the tax code tremendously benefits people already.

For many millennials, being debt free is a proud badge of honor. Many strive to pay down student debt as fast as possible — to put that chapter of their life behind them and move on.

Eliminating debt becomes a higher priority than maximizing wealth.

The result is millennials pay down tax efficient debt in a tax inefficient manner.

This approach lessens the opportunity to achieve financial independence or early retirement.

Here’s How To Pay Student Loan Debt To Maximize Wealth:

A quick 5% example: An extra $1,000 to pay off student loans means you’ll save $50 on interest. If you put that same income into your 401(k) then it is pretax, so $1000 is actually ~$1,300 (25% tax rate). Adding in $40 net interest ($50 of interest lowers your tax bill by ~$10) and you’re saving $260.

Outside of the additional monetary gain of $210, the real benefit of this tax-efficient approach is the intangible benefit associated with developing the habit of saving early in life.

Recently, I was asked by a reader, why I care so much about personal finance. The answer is because I love to figure out ways to make the system work for you instead of against you.

Needless to say, investing in your future has a positive impact on any individual, and in many cases, a couple or a family.

Applied on a personal level, this strategy saved me an extra $7,000 in 2015 alone. More importantly, it removed the stress of student loan debt from my relationship & given my girlfriend and myself confidence that we’re ready for the next steps in life (i.e. marriage, homeownership, starting a family, taking care of our parents, etc.).

How Emotions Factor In
As with all form of investing, being aware of your emotions plays a critical role in sticking with a strategy. Maintaining the courage of our convictions is easier said than done.

The choice is between feeling good about having less debt OR feeling good about having more wealth.

Which of these would you be happier with?

The answer is not black or white; it depends on the individual. A big factor that could lead to having less debt is if the interest rate on our loans was much higher than the example provided above.

I would argue the emotional benefits of maximizing your wealth surpass the benefits of having less debt.

By taking the opposite approach to student loans, we can realize early retirement and financial independence at an early age. Or, if someone prefers, they can more easily afford nicer cars, luxury vacations, and/or a bigger house.

For me, buying my future freedom is the expensive purchase I have my sights set on.

The benefits and costs of paying into a 401k vs paying extra money towards student loan debt is NOT obvious and it is NOT part of a standard high school curriculum.

There is even a minor degree of controversy in this approach. I can tell you from firsthand experience how many looks I get when I say I’ve poured every dollar into the stock market instead of paying my student loans. People will look at you funny.

Five More Benefits to This Tax-Efficient Strategy – In Case You’re Not Convinced Yet:
1. If you have student loan debt right now, you can tap into these rewards right now. You don’t need to wait to purchase a house or have a small business.

2. When an individual rushes to pay down student loans, they often don’t translate all the student loan payments into retirement contributions when they’re done. More often, the reward is buying something and increasing the spending on various categories.

3. As a percentage of your income, the amount of money going to pay down student loans should inherently decrease, assuming your income is rises.

4. Building up a pre-tax account leaves you with an asset. Worst case scenario, you could tap into with fees and interest. Think of it as the safety net you want to avoid, but it is there if you absolutely need it.

5. The last benefit I’ll mention here is student loans serve as a hedge against inflation.

To a lesser extent, this approach works with mortgages as well, but I will leave that discussion for another day.

So the next time someone asks you, “What’s the quickest way to pay off student loans?” consider whether they’re aware of ALL of their options.

Let me know what you think of this approach in the comments below.

Matt
Master Distiller

*http://www.marketwatch.com/story/every-second-americans-get-buried-under-another-3055-in-student-loan-debt-2015-06-10

**http://www.bloomberg.com/news/articles/2016-03-02/how-to-pay-school-loans-and-save-for-retirement-at-the-same-time

25 comments… add one
  • Kyle Mar 10, 2016, 9:42 pm

    I saw your twitter name distilleddollar, the beer brewer in me had to check this out.
    A couple years ago I dropped $6k on student loans I think they were 6.25%. Then later I learned more and realized since student loan interest is tax deductible those interest rates are essentially a few points lower in terms of money out of pocket per year. I then realized I’m better off taking the tax benefit of retirement accounts and expecting the roughly 7 or 8% ROI per year on top of that on the money I invest rather then paying low interest debt down. I still hate debt, but the logic is too strong for me to ignore, I’ll play the game.
    ” why I care so much about personal finance.” aren’t you baffled most people don’t? To me, it’s one of the most important things in our daily lives. Everything surrounds money, We go to school to earn more money, we work 40-60 hour week jobs for money for decades in a job most people hate, usually until we’re 70 years old for money. The Idea that that vast majority of your life surrounds working for money, and you’re not the least bit interested in your finances or how your money is invested or if you even invest, and your not interested in money management…. Wow.. that’s the vast majority of people too.

  • Distilled Dollar Mar 10, 2016, 11:33 pm

    Excellent points and thanks for sharing! Props for being a brewer!

    I agree that personal finance should be a small focus in everyones life. Sadly, most people I run into are spending that time stressing about money instead of learning about money.

    If you want to see more of my thoughts on this same topic, check out: http://distilleddollar.com/2016/02/23/how-we-went-from-earning-a-living-to-building-wealth/

  • Allan @ The Practical Saver Mar 14, 2016, 5:03 pm

    If I had student loans under my belt, I would choose to invest my money first before pay for the following reasons:
    1. Student loan interest is tax deductible.
    2. I can use the money towards investing in the stock market (especially when the stock market is down and I have the opportunity to buy more shares).
    3. I could use the money towards retirement.

    In addition to do this, I would spend my money towards other important things in life:
    4. I could use the money to fund my emergency fund (I wouldn’t feel comfortable knowing that I may find myself in need of funds when rainy day comes and I have no money because most, if not all, went to paying the student loans)
    5. If I had student loan, I would pay it but won’t make it my priority. I am not going to earn money to only pay my student loan. I am going to earn money because I want to have fun and, at the same time, save. Like what I told my friends, “you didn’t graduate school to just pay for your student loan debt.”

    • Distilled Dollar Mar 14, 2016, 7:30 pm

      Great points and I couldn’t agree more on building a cash buffer and/or asset buffer.

      It scares me to think you can pay multiple times the required payment each month and then not receive any type of break in the off chance you lose your job and are unable to make the standard monthly payment.

      From my experience, those who go on a Spartan lifestyle to pay down student loan rapidly, often have a hard time with budgets and keeping spending low once the payments are done.

    • K Mar 21, 2016, 9:19 am

      Student loan interest is only tax deductible to a point. You can only deduct a max of $2,500 in interest, which gets you a refund of $600, and you only get the max refund if you make less than the income limits ($80,000 this year for single filers).

      Is paying $2,500 to save $600 worth it?

      • Distilled Dollar Mar 21, 2016, 9:33 am

        I provide a similar example above on how $1,000 into student loans saves you $50 vs a savings of $260 with retirement accounts.

        The largest benefit is from income taxes. The reduced tax liability from student loans interest is an additional, smaller benefit.

        I’m other words, is saving $2,500 on interest worth paying $10,000+ in additional income taxes?

        I’m assuming 50k loan with 5% interest to arrive at 2.5k interest. Paying off 50k would mean ~70k income. An extreme example but one that might illustrate the math in a different way.

  • Nurse on Fire Mar 19, 2016, 4:08 am

    While I feel you make an extremely valid argument here, I must respectfully disagree from my personal position. My wife and I graduated in 2013 with a combined total of about $84k worth of student loan debt. I’m EXTREMELY fortunate, working for the Indian Health Service, that my share of that (about $54k) is being paid off through my work commitment. We got pregnant a few months after graduating, moved to the middle-of-nowhere South Dakota from Illinois for my job, and she has been an incredible stay-at-home mom to our awesome son…the catalyst of our PF awakening!

    I discovered Dave Ramsey around the time our son was born in September 2014 and we quickly paid off our credit card debt; then, for whatever reason, we slacked off on debt payments and started investing. I felt that this, in combination with paying on my wife’s student loan, essentially spread us too thin and it was as if we were more-or-less spinning our wheels. Within the past few months, we got ourselves back on track, dropped the investments to maintain my employer match, are now slamming as much money as we can at my wife’s loans, and are on track to be debt-free (with the exception of our Jeep) within the next 14-ish months.

    Based on some rough calculations, paying the loans off this quickly, as opposed to stretching it out over the next 8 years is only going to save us about $5,000 in interest. While you’re math makes perfect sense, as investing in tax-deferred accounts would save more than this in taxes in a shorter amount of time, I believe the “emotional benefits” of reaching debt freedom will be priceless, allowing us to then translate those funds over to investments – like you said, that’s a extremely important factor that certainly not everyone will do. Having a clear plan for reaching goals (i.e. FIRE, in our case) is paramount to this plan being a success. It should be noted that the arguments you make for this, I am applying to our Jeep loan. We financed it new prior to our personal finance epiphany and we have every intention of keeping it until the wheels fall off…lol. It’s at a mere 2.24% interest rate so investments will be cranked up into overdrive prior to it getting paid off.

    All-in-all, it’s like you said, there is no single right way to do things and personal finance is just that…personal. I applaud your methods and rationalization. For me, I’ll be doin’ my happy-dance when those loans are no longer on our shoulders. Excellently written post, sir. 🙂

    • Distilled Dollar Mar 19, 2016, 1:01 pm

      You hit the nail on the head when it comes to understanding emotions in any investment approach. Having the awareness of your own emotions and goals can never be understated because emotional turmoil often destroys even the best financial approaches. Given life is naturally a bumpy ride, it is wise to plan ahead with a strategy you can be aligned with on an emotional as well as logical level.

      You also make a great point on personal finance being personal. It sounds so simple but it is very true.

      I’m glad to see you liked the post!

      • Karlene Jul 22, 2016, 8:15 am

        I totally understand Nurse on Fire’s response, and appreciate your response Distilled Dollar.

        Based on my reading of your blog and comments thus far I believe my husband and I are much older than most of you, and I feel that might cause me to look at things slightly different.

        I am the money manager in our family; my husband does not want to deal with it, and I am perfectly happy to do it. One of these days he will eventually look at my plans to become debt free and build up our wealth. In the meantime, I am happily plugging away at both on my end, while supporting him in every way possible.

        I have never ever liked owing anyone for anything. However, I am also of the belief that everything happens for a reason, whether or not it is completely clear. Therefore, I know that I helped to create our ridiculous amount of debt to help us both to become the truest forms of ourselves. I feel like we are growing in all respects and it is now time to let go of all this debt baggage, and move into our wealth.

        Thank you for sharing your thoughts on the topic as it might help others who need to get your message. Have a wonderful day.

        • Distilled Dollar Jul 22, 2016, 5:06 pm

          Thanks Karlene!

          It sounds like you’re on the right path – I’m looking forward to seeing your progress over time!

  • Andrew@LivingRichCheaply Mar 20, 2016, 9:54 pm

    You make great points and so do the commenters in the comments section. I graduated with a decent amount of student loan debt but was very fortunate that most of them were extremely low interest rates. I mean really low. I have some in the 2 to 3% range so I’m not in a hurry to pay them off, I prefer to invest. I did pay off a portion of my loans that were 6.8%. Like Nurse on Fire says, personal finance often has more to do with emotions than pure math, and I’m more of a math guy. I’m okay with low interest debt and don’t plan on paying it back early.

    • Distilled Dollar Mar 20, 2016, 11:38 pm

      You mentioned you paid off a portion, so does that mean you stopped paying extra payments at some point? If so, I’m curious what made you switch in your approach?

      Similar to you, the only high interest loans we have on our plate is the monthly credit card bills that we do pay off on time. Otherwise, we are fortunate enough that everything else is closer to the 5% range.

  • Andrew Mar 21, 2016, 8:46 am

    Sorry, I probably wasn’t that clear. I was making extra payments to my loans that had interest rates that were 6.8%. I lowered the amount the loan and was able to pay it off with a lump sum. Now the majority of my loans are in the 2 to 3% range.

    • Distilled Dollar Mar 21, 2016, 9:19 am

      Thanks for clarifying. Yep, once the interest gets higher, then the support for my approach becomes less and less effective.

      It is great to see you’re investing instead of paying down those very low interest rate loans.

  • MBB_Boy Mar 23, 2016, 4:09 am

    You “save” on taxes this year…..but you eventually pay them in the future. There is no savings, just a deferment. Why isn’t that part of your story? And none of your main point even applies to us ROTH folks

    The only real savings is the interest you avoid by paying your loans early. Maybe you make some money in the market short term ( need to beat your student loan interest + inflation in order to make anything)….but with a historical market return of 8% and inflation of 2%, you’re probably coming out on the losing side of this.

    Of course, employer match take precedence over extra student loan.

    • Distilled Dollar Mar 23, 2016, 6:12 am

      The tax savings are made permanent by using what is known as a Roth IRA Conversion Ladder.

      Basically, you convert a small piece of the Traditional IRA & 401k income into a Roth IRA once you reach financial independence and during the early retirement years. Given you have zero to low income, you can then convert the amount tax free and making the savings permanent. If you have a larger amount to convert with a shorter timeline, then you will be subject to 10% or 15% of ordinary income taxes. In the examples I have seen, the taxes have been minimal due to a long runway before 65.

      I appreciate you taking the time to comment. It made me realize I need to discuss the Conversion Ladder and other tax strategies in this post or in another article.

      You’re definitely right that the tax benefit is minimized if you opt into a Roth IRA or Roth 401k. You will not have the tax savings up front so you have nothing to work with down the road.

      I hope the market continues to earn 8%, but personally I’m expecting closer to 6% or 7% moving forward. You forgot to mention dividends which have historically been ~2% so we both end back at around your 8% number.

      • Mbb_boy Mar 25, 2016, 2:13 am

        Actually, looks like the oft cited 7% long run average already includes both dividends and inflation
        http://www.simplestockinvesting.com/SP500-historical-real-total-returns.htm

        Definitely an interesting idea, and I have seen a lot of other articles about Roth conversion ladders- but I’m planning on $150k a year so it’d be impractical for my family- converting that much will still have me with a high tax liability (greater than today depending on how government goes)
        Granted, I haven’t spent a lot of time looking at the most tax efficient withdrawal strategy (capital gains vs Roth vs your conversion strategy) since I’m in my mid 20s and I’m sure the laws will be completely different in 20 years 🙂 At this point, it looks like I can take about $70k in capital gains free of tax, and then would pay 15% for everything past that( but I paid tax to invest in the first place)
        For Roth contributions, withdrawals have 0 tax (but I pay tax up front, like the money in the capital gains bucket)
        Your conversion ladder would allow me avoid taxes completely to a point (equal to deductions), but I won’t be able to convert enough to hit my goal (but some is better than none, right?)

        Either way, I’m wary that both the backdoor Roth and the ability to convert traditional to Roth (basis of conversion ladder)will be very different or gone when I’m looking to really use the strategies.

  • Dames in Debt May 4, 2016, 3:58 pm

    This is an interesting strategy, and one that I am actually doing, albeit accidentally. I’m making extra payments on my one, private student loan, but the rest of my loans (all Federal) are just hanging out in income-based repayment land. With the extra I’m not spending on those loans, I’m able to contribute to my retirement accounts.

    I’m qualified for Public Interest Loan Forgiveness since I’m a Public Defender, so that’s why I never wanted to maximize paying off my student loans. I’m glad the math works out in my favor on this one, and I’m very happy to have some more arguments in my arsenal for when people question my method.

    • Distilled Dollar May 4, 2016, 7:57 pm

      The Public Interest Loan Forgiveness sounds amazing. I hear being a Public Defender is a real demanding job so props for that as well!

      The tax savings from this approach work particularly well for early retirees. Basically, if you can transfer some of the pre-tax accounts into post-tax accounts via an IRA Conversion Ladder, then you can lock in 90%+ of the tax savings.

      If you’re interested in seeing more numbers and even seeing why the IRA is better in a non-early retirement environment, you can listen to this interesting podcast from Radical Personal Finance. Basically, if you can pull out the INCOME of a 401k or trad IRA early, even with the 10% penalty, you’ll still come out ahead compared with putting your money into a Roth. Again, its an interesting podcast and more support in case you need it!

  • Pamela Sep 30, 2016, 2:56 am

    I never thought of student loans being a hedge against inflation. You make a really good point. In looking back I wondered if should have maxed out my RRSP (that’s 401k in Canada talk) or paid off our (me and my husband) loan of $120k at 5.5%. We went with paying off the loan.
    However I do agree with point #2, many just increase their spending after paying off their student loans. To avoid this we decided to keep a savings rate of 35% to 40% and save about $40k a year to make up for lost time and money.

    • Distilled Dollar Sep 30, 2016, 6:28 am

      I would say you made a great decision since you had the strength of mind to keep up the savings rate. At the end of the day, utilizing cash flow to invest or pay down debt is a great decision either way. Much better to have that money being used to increase your net worth than just spending it.

  • Melanie (MindfullySpent.com) Nov 7, 2016, 2:53 pm

    I needed this. We have been working on paying down all debt except our student loans at the moment due to their low interest rate and the fact that we will qualify for public service forgiveness if we continue in public service. Because of how many folks rush to pay them down, I was starting to question that logic. No more!

    • Distilled Dollar Nov 7, 2016, 3:15 pm

      Yep – I’m all about keeping the minimum payments and refinancing down the rate. Then, once you max out pre-tax accounts, then we start to accelerate debt payments.

      This approach isn’t for everyone – but it has worked wonders for us.

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