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:

  1. fund 401(k) enough to capture any corporate match
  2. accelerated payments on debts
  3. max out your Roth
  4. further fund 401(k) to the corporate (or IRS) limit
  5. 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.

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Guest's picture

As a general rule, wouldn't you say that paying down debt first is better? The questioner's situation is not typical. Also, with a salary "jump," perhaps the questioner could do both!

Guest's picture

Wish I had her problem. Let's add another wrinkle to your 1-5 list of where my money ought to go. What if my employer stopped matching my 401(k) contributions? Should I continue to put in what I was before? Should I shift that to paying off debt? Should I shift that to a Roth?

Philip Brewer's picture


Right—paying down debt first is generally better. In this case it would just be a matter of reducing the amount of debt pre-payment  by a quarter (she mentions suspending the extra debt payments for three months), and that seems like a reasonable trade-off to me, in exchange for a shot at decades of tax-free growth.


If there's no employer match it gets a lot harder to decide whether to prefer the tax-deferral of a regular 401(k) or IRA versus the forever-tax-free growth of a Roth. Which will turn out to be better really depends on whether tax rates will be higher in the future. But since currently tax rates are at multi-generational lows, I'm betting that future tax rates will be higher. That tends to make tax deferral less attractive than tax-free growth.  

I'd be inclined to prioritize debt reduction over either one, except for the pay-yourself-first aspects of a 401(k). If you can really, really put all the money into debt reduction, then I expect you'd come out ahead getting the debt paid off first. But if even a little of the money ends up getting spent simply because it makes its way into your checking account, I expect you'd end up behind. As long as contributing to a 401(k) does stretch your debt repayment off into the distant future, and as long as the debt isn't at outlandish interest rates, I'd stick with 401(k) contributions, even without the corporate match.

Guest's picture

Where would you say that creating an emergency savings fund equal to 3 months of living expenses comes in your queue? Have heard everything from emergency savings first to accelerated debt payment first... sometimes both in the same article!

Philip Brewer's picture

@kimatsprig: I wrote a post on when to use savings to pay down debt, an analysis which turns on exactly that question—what about the emergency fund? Another way to think of it is is, What's the right size of emergency fund for someone who has debts?

Saving money on interest payments points toward a smaller emergency fund.  Still, I don't think an emergency fund of zero is the best choice, simply because that can be an expensive choice—an emergency fund of zero leaves you exposed to all manner of little glitches in cash flow causing the sort of problem that can lead to late payment fees, bounced check fees, and worse.

So, if an emergency fund of zero is too risky, but a full-blown 3-6 month emergency fund is too expensive, what's the best choice? My take is that something in the area of $1000 or one month's expenses is the sweet spot. It's enough money that little glitches like a hiccup the delays your paycheck over a holiday weekend won't cause cascading failures. I'd suggest that even a minimal emergency fund out to be at least as big as your biggest monthly bill—so you can handle the situation where your payment goes astray and you have to temporarily cover the bill again until things get sorted out.

Guest's picture

Being debt-free makes it easier to handle an emergency. That would tilt my decision towards debt repayment rather than locking my money into a retirement fund I can't get to for years.

Also, life is easier and less stressful if we have fewer bills to pay attention to. That argument would favor paying off small debts ASAP.

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The government imposes contribution limits on all types of IRA. The Roth IRA Contribution Limit rules can change. It is essential that you review this, at the beginning of each new financial year. This will ensure you understand the maximum dollar amount you are allowed to deposit in your IRAs for that year.

Roth IRA