As thousands of college students graduate and transition into the workforce, they will likely have many questions about their finances. A concern that I have seen specifically within the millennial demographic is the debate between paying off student loans and/or contributing the maximum to an employer 401(k) plan.
The reason that many may suggest paying off a student loan first is the “opportunity cost” of paying that specific debt and no longer being tied down to the interest rate that is attached to the loan. It’s true that you get a guaranteed return if you pay off the loan (typically around 6.9 percent with today’s lending standards), but if you invest your 401(k) assets in an all-equity portfolio (since younger investors can afford to participate in “more aggressive” allocations) the return is likely to be greater than 6.9 percent over time. The S&P 500 has had a return of 7.65 percent over the past 10 years (as of 12/5/13), which includes one of the worst bear markets (2008) we’ve seen since the early 70s.
Aside from investment returns, the benefits of contributing to, and focusing on a 401(k), far outweigh plans to first pay off student debt. Our argument is to focus on retirement contributions first and foremost, and follow that by paying down/off student loan debt. Consider the following advantages:
1. Establishing a strong savings mindset early on. Transitioning from school into the workforce can be overwhelming for younger adults, especially as they begin to receive their first full-time paychecks and suddenly have the cash flow that they didn’t necessarily have throughout college. By contributing to a 401(k) early on, millennials force themselves to get into the habit of saving money for retirement.
2. Compounding over the decades. By aggressively contributing to a 401(k) early on in your 20s, the investments have the chance to compound over what will likely be the next 40 years. By focusing on paying off debt first, and focusing on a 401(k) second, millennials miss their chance to start this fund and will have to contribute a higher deferral percentage later down the road, with a lessened guarantee of benefitting from extra years of compounding.
3. Tax benefits. Especially with certain retirement vehicles, such as a Roth IRA, the tax benefits over time work in a millennials’ favor.
Getting a jump start on 401(k) contributions as early as possible is vital to securing the foundation of your retirement later in life. For millennials, it may be difficult to think about retirement in the “here and now,” since it is four or more decades away, but by contributing the maximum amount as soon as possible, it will set this generation up for success when they near the golden years of their life.