These days, it's not uncommon to graduate college with a pile of student debt. And if you're paying a lot of interest on those student loans, you may be tempted to prioritize their repayment above all else -- including your retirement savings.
If you're a fairly recent graduate, that logic makes sense. With retirement decades away, you should, in theory, have ample time to first pay down your student debt and then focus on building a nest egg. The trouble is that delaying your retirement savings for too long could hurt you financially down the line. That means that there are many circumstances when trying to knock out your student loans first will not help you in the long run.
You can only put off retirement savings for so long
If you're sitting on a relatively small amount of student debt with a relatively high interest rate attached to it (which is likely the case if you took out private student loans for college), then it could be a smart move to delay your retirement savings for a number of years so that you can pay off those loans.
After all, based on the market's historical returns, if you load up on stocks, your retirement savings might generate an average of 8% a year over time. If you are paying 10% or more in interest on your student loans, it could save you quite a bit of money to knock them out before you start investing for the future.
On the other hand, if you think it'll take more than a decade to pay off your student loans in full, then you'll need to find a way to incorporate retirement savings into your budget while also keeping up with -- and ideally, getting ahead of -- your loan payments. If you hold off on retirement savings for too long, you run the risk that you won't have enough money to pay your living expenses when you're older, and that's not a situation you want to be in.
Imagine you're able to set aside $300 a month for retirement -- a respectable amount -- starting at age 42, because it takes you until then to pay off your loans. If you're looking to retire at age 67, you have a 25-year window to save for your future. And if you invest your monthly $300 contributions at an average annual 8% return, you'll grow your savings to $263,000. That's not a small amount of money to have in retirement, but it's also not a lot. And because many financial experts advise withdrawing from retirement savings at an annual rate of 4% during your golden years, a balance of $263,000 only gives you about $10,500 in yearly income.
If, however, you find a way to start saving that $300 a month 10 years earlier (even if it means taking longer to pay off your student loans), you'll have $620,000 in your nest egg by the time you retire, assuming a retirement age of 67 and an 8% average yearly return on your investments. At a 4% annual withdrawal rate, that gives you access to $25,000 a year in retirement income.
Keep in mind that your retirement plan withdrawals will be in addition to the Social Security income you collect; but still, the more you have in savings, the better.
Saving for retirement yields other savings, too
Another thing to keep in mind is that the more money you put into a traditional IRA or 401(k), the more of your income you exempt from taxes, up to the annual limits (which are currently $6,000 and $19,000, respectively, for workers under 50). This means that if you save $300 a month in your retirement plan, that's $3,600 of annual income you won't pay taxes on.
This in turn will save you money and give you more cash to work with as far as paying off your student loans goes. Also, because many companies that sponsor 401(k)s offer free money in the form of matching dollars, it rarely makes sense to pass up that opportunity.
Now, to be fair, you can score some modest savings by deducting your student loan interest on your taxes. But you're limited to a $2,500 deduction, whereas with a traditional IRA or 401(k), the tax benefits are much higher. And, if you're a higher earner, that deduction phases out or goes away completely, whereas you can contribute to a traditional IRA or 401(k) regardless of how much you earn.
Don't neglect your savings
Tax breaks aside, the primary reason to not wait until you're student debt-free to fund your nest egg is that you don't want to miss out on years of compounded returns that help you grow your wealth.
Remember, while you may be used to the idea of borrowing money for college, you can't take out retirement loans, at least not in the conventional sense. You need to have money in savings to cover your living expenses when you're older. And although it may be nice to shed your student debt before focusing on other types of savings, the reality is that in most cases, you'll need to learn to juggle both at the same time.