Contributing to a Roth Versus Paying Down Debt
This post was prompted by a reader question, but it's an issue that many people face — we see versions of it all the time in the forums. So, I thought I'd walk through what I think is the best way to approach any problem of this sort. It starts with comparing interest rates, but it ends with a comparison to lottery tickets.
The general solution to this kind of problem is to compare rates of return: Is the interest that you have to pay on your debts higher than the return that you can expect get on your investments? If it is (and it usually is), then pay down the debt.
In fact it's even stronger than that, because there's the asymmetry between the interest that you have to pay versus the return you're only expecting to receive. It wasn't long ago that lots of people were expecting to receive 12% (or more) on their stock market investments.
Based on that, here's my starting place on where your money ought to go, after you've covered your household expenses and the minimum payment on any debts:
- fund 401(k) enough to capture any corporate match
- accelerated payments on debts
- max out your Roth
- further fund 401(k) to the corporate (or IRS) limit
- regular old (after-tax) investing
(Sometimes it makes sense to skip step 4 and go straight to step 5. I talk about that in my post When NOT to put money in your 401(k).)
The reader's question, though, has to do with partially skipping step 2 (accelerated payments on debt) in order to get to step 3. Here's what she asked:
Thanks to a recent promotion, my salary jumped to $100k. The one downside is that I may only be able to contribute to my Roth for 2009 and maybe 2010 (it's my understanding that the income limits to convert will be eliminated in 2010, but the limits to contribute will remain, and start at $105k for single filers). I'm aggressively paying down student loans and will finish by November, but since 2009 may be the last year I can contribute to a Roth, I'm thinking of stopping the extra loan payments for 3 months in order to contribute the $5k max to my Roth for 2009. I contribute 9% to my company 401k and receive an employer contribution of around 7%, my mortgage is my only other debt, and I'm late 20s. My overall retirement savings is lower than I'd like (the loans have been my priority), and I planned to max out contributions once the loans are gone.
My answer is: Yes, it makes perfect sense to fund the Roth under these circumstances, even though it means that the student loan will take a bit longer to pay off. In fact, it might well make sense even without the special circumstance of having only this narrow window within which to contribute to a Roth.
Usually it makes more sense to just get the debt paid off, which is why step 2 comes first. That's because the interest owed on debt is usually higher than you can reliably earn on your investments. But the Roth is a special case because of the tax advantages and the very long time-scale. Money invested in a Roth by a 20-something has the opportunity to grow tax-free for decades — and then you never have to pay taxes on the earnings.
With those advantages, your gain in the Roth is very likely to match the extra interest you end up paying. On top of that, there's a real chance that, over a few decades, it'll do much better yet. To my mind, that tips the scales: Your cost is low and predictable (the extra interest) and your gain can be reasonably expected to match it — with a substantial chance of an outsized win.
Here's another way to look at it. Investing instead of paying down debt is kind of like buying a lottery ticket. You pay $1 and can expect to win (on average) something like 50 cents — but with a small chance that you'll win thousands of dollars. Because of the unique advantages of a Roth, in this case it'd be like buying a ticket for $1 and expecting that your average return will be very close to $1 (the expected return on your Roth will be close to what you're paying on your student loan) — but you still keep the chance that you'll win thousands of dollars, because of the future decades during which your Roth has the opportunity to rack up tax-free gains.
I think it makes good sense.