When Saving for Retirement Beats Paying Off Your Student Loans

Rising student loan debt may be hampering young people's ability to buy homes or even move out of their parents' basements. But that does not mean student loan borrowers always should be in a hurry to pay off this debt.

In fact, young borrowers could wind up poorer in the long run if they prioritize rapid debt repayment over saving for retirement, financial planners say.

That's because retirement contributions typically offer tax breaks, company matches, and future compounding that are worth far more than the interest saved by accelerated student loan repayment.

"People focus on the now and keep putting their retirement savings farther away," says Conner Kolodge, wealth manager for Accredited Investors in Edina, Minn. "That can be a costly mistake."

As more young people incur student loan debt in ever-increasing amounts, it's essential that they understand the costs of prioritizing debt repayment over retirement savings, planners say.

A recent TransUnion study of "credit active" consumers—people with at least one credit account or loan—found that 51% of those aged 20 to 29 now have student loan debt, compared to 31% in 2005.

Balances have soared as well, the study found. The average balance for a 20-something borrower in 2014 was $25,525, compared to $15,853 in 2007. That's a 60% increase.

An Experian study found an even greater rise in student loan debt when the rest of the population was counted in. Experian's study of its own credit reports found student loan debt had risen 84% between 2008 and 2014 and that the average balance for borrowers of all ages was $29,000.

Bachelor's degree recipients who graduated in 2014 with debt owe an average $33,000, according to financial aid expert Mark Kantrowitz, publisher of Edvisors.com, a college finance resource site.

But even that amount of debt isn't prohibitive as long as the graduate lands a job with an annual salary that tops that amount—something college graduates typically do, Kantrowitz says.

Census Bureau data shows that for people aged 25 to 34 in 2012, the median earnings for those with a bachelor's degree was $46,900, while the median for high school graduates without a college degree was $30,000.

"If total student loan debt at graduation is less than the annual starting salary, the borrower will be able to repay his or her student loans in 10 years or less," Kantrowitz says.

Meanwhile, saving for retirement often gets harder, not easier, as people age and incur other financial responsibilities, planners said.

"I wish I could get every single one of [clients in their twenties] to set aside 10% from the beginning of their careers," says financial planner Delia Fernandez of Los Alamitos, Calif. "Then I wouldn't have these 40- and 50-year-olds in my office struggling to catch up for their retirements."

How the Math Works

Company matches offer an instant, free return of up to 100% on worker contributions. The most common match, according to Aon Hewitt, is dollar for dollar up to a specified percentage of pay, typically 6%. The next most common match is 50¢ per dollar contributed up to 6%, the human resources consultant found.

Even plans without a match offer tax deductions, tax deferral and sometimes tax credits. The value of the deduction depends on the worker's tax bracket, which is typically 15% to 25% for federal taxes and is often higher when state and local taxes are included. Lower income workers can qualify for a tax credit of up to 50% of their contributions. Contributions and earnings grow tax free until withdrawn.

Thanks to compounding, contributions made when workers are in their twenties can be worth twice as contributions made later. That's because the money has longer to grow.

A $1,000 contribution made at age 25 would typically be worth $20,000 or more at retirement age, while the same contribution would be worth about $10,000 when made at age 35, assuming 8% average annual returns. Even if participants don't achieve 8%, which is the historical stock market average for periods over 30 years, the math still holds: contributions made earlier return dramatically more.

Those returns tend to dwarf the value of prepaying student loan debt, especially for recent graduates. Interest on student loans is typically tax deductible, which reduces its effective cost. Someone in the 15% bracket would have an effective cost of less than 4% on a Stafford loan with a 4.66% interest rate. A 25% tax bracket would lower the effective cost to about 3.5%.

Higher rates—such as those charged on older federal loans and on many private loans—are more problematic and may need to be paid off more rapidly. But that debt payment still shouldn't come at the expense of company matches, financial experts say.

"Borrowers should always make the required payments on their federal education loans, since the penalties for default are severe," Kantrowitz say. "But otherwise they should maximize the employer match on contributions to their retirement plans, since that is free money, before devoting extra money to accelerating repayment of their student loans."

Related:

• Should I save or pay off debt?
• How do I figure out my financial priorities?
• How much should I put in my 401(k)?