One of my goals for today has been to do some retirement planning. We've gone to a couple of financial planners recently, and they've been good about helping to make high-level choices: what kind of income to aim for at retirement; what kind of return to expect, etc. But they've been less helpful about making low-level decisions. One question that's particularly relevant to us is whether money should be used to pay off loans at a faster than normal rate, or to invest it into IRAs or other retirement plans. The first planner suggested that it's wrong not to max out your IRA, without any real explanation why. (Even if I believed this, it's not 100% helpful, since we also have a 403b plan allowing for a large amount of income to go tax-deferred, and I doubt we will max this out.) The second was even worse, saying "well, you want to put some money into loans, some into IRAs, some into ...". So I've had to sit down with spreadsheets to figure this out myself, and I think I have the answer now.
I compared two scenarios having a budget of $1000 each year for two years. The first scenario involves putting money towards a loan in the first year and putting it into a (tax-deferred) retirement fund the next. The second one is switched around, putting money into the IRA the first year and paying for the loan the second. Here's what it looks like:
|Scenario 1||Scenario 2|
|Paid to loan||1000||0|
|Paid to IRA||0||1344.20|
|Paid to loan||0||1000|
|Paid to IRA||1449.27||0|
The "Paid to IRA" columns require a bit of explanation. In scenario 2, we have $1000-72.50 to invest in the IRA. (The $72.50 goes to pay the extra loan interest not present in scenario 2.) However, that's $927.50 post-tax dollars, which at our tax bracket (31%) is the same as $1344.20 in pre-tax dollars. Similarly, in scenario 1, we invest $1000 post-tax, which is $1449.27 pre-tax. This tax break gives the second scenario a slight advantage at the given interest and return rates (7.25% for the loan, 8% return on the IRA.) So it makes sense to put any "extra" money you have into the IRA first, and overpay on the loan the next year. And since you can make the same argument for the following year, you should in fact put as much money into your IRA as you can and pay off your loans as slowly as possible.
In fact, we will probably pay off our student loans first before putting money into retirement, since the 8% return is only an estimate and it carries with it some form of risk. As return in scenario 1 is nearly the same, and it's risk free, it seems overall a better strategy. All our other loans are at significantly lower rates (except the second loan on the house, but even that's at a lower effective rate once you take the tax deduction into account), so it makes sense to put money towards retirement first and pay those loans off slowly.
Curiously, the break-even point between the two strategies doesn't depend on the tax bracket:
IRA return = 1/(1-loan rate) - 1
Next step: Roth vs. traditional IRAs.