Paying Down 6-Figure Student Loans vs Investing in 401k

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RolandTHTG
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Paying Down 6-Figure Student Loans vs Investing in 401k

Post by RolandTHTG »

Hello,

I'm a longtime lurker, and I'm very grateful for all of the knowledge I've gained from reading these boards. I know there are quite a few threads already on the topic of investing vs. paying down debt, but I'm still struggling with choosing the right course of action in my case. So with apologies for starting yet another thread on this topic, here's my basic financial info:

Emergency Funds: 6 months expenses

Debt: My student loans are slightly over $150,000 all at fixed rates ranging from 5% to 7.8%, with a weighted average of 7.6%. Spouse's student loans are nearly identical, so a total of $300,000 between the two of us. No car loans, no credit card debt, and we rent, so no mortgage.

Tax Filing Status: Married filing Jointly

Tax Rate: 33% Federal 6% State (It looks like we'll also be subject to AMT in 2012.)

Age: 28

Neither of our employers offer a 401k match.

My question is which of the following options would you recommend:

A) Each contribute the max $17,000 to our 401k's and put whatever is left over to the loans. If we do this, I estimate that we would pay off the loans in about 9-10 years.

B) Put everything we can toward the loans and skip retirement contributions entirely until the loans are paid off, which I estimate we could do in about 5 years.

I know that the standard advice is to pay off any high interest debt before starting to invest. But does that advice change if we're facing a 39% federal+state marginal tax rate? Just from a psychological point of view, my preference would be to pay off the loans as quickly as possible, but I'm also nervous about the idea of not starting to save for retirement until age 33 or later. There could also be an option C, which would be contributing a smaller amount to the 401k's (maybe $2,000-$5,000 each) and everything else toward the loans as a compromise.

Thank you in advance for any advice you can share.
awval999
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by awval999 »

Dual lawyers? Too young for dual MD's imo.

As a pharmacist with ~$100K in SL and in the 28%+5% marginal brackets, here's what I did:

1. I invested in my 403b to the match (when I started on Day 1)
2. Saved up an 8 month emergency fund, which was $25K (took me 18 months)
3. Maxing my 403b at $17K/year (Increased my withholdings this month for 2012)
4. Time to suicide those loans with all my extra money (just started)

Of course I went to Hawaii and enjoyed myself as well. I just kept my old college beater for my car and am still renting.

Good luck.
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market timer
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by market timer »

The 401K space is really valuable, but so is 7.8% tax-free. I'd suggest maxing out your 401K, then take out 401K loans to pay down your debt. It should take 3 years to pay off your debt, not 9. Also look into 0% APR credit card promotions to accelerate debt repayment.
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ray.james
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by ray.james »

Interesting scenario! I would love to see what others suggest.
Look at the grabiner response on this thread: http://www.bogleheads.org/forum/viewtop ... =1&t=85997
with fed+state + payroll, aggregate taxes come down to 36%(roughly). Your scenario - 401k plus 6-7 year loan pay off (VS) 3-4 year straight pay off. Personally at that marginal tax bracket, I would contribute maximum to 401k.
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beareconomy
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by beareconomy »

The only fail of first investing in the 401k then taking out a loan is they may not allow you to do so depending on the plan you have. Also, with an outstanding 401k loan, you may not be able to contribute to the 401k the next year.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by livesoft »

beareconomy wrote:The only fail of first investing in the 401k then taking out a loan is they may not allow you to do so depending on the plan you have. Also, with an outstanding 401k loan, you may not be able to contribute to the 401k the next year.
Yes, "may" is the operable word and easy to check. My spouse took out the maximum 401(k) loan possible, was able to keep contributing and even made more money from the loan than if there was no loan. Her 401(k) loan was such a great idea that I am consider one myself.

The 401(k) loans would only be a partial answer though as they are limited to $50K or half the 401(k) value with the payments coming from one's paycheck.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by JW-Retired »

Market Timer's loan maneuver is a good idea, but with or without it I would go for the max amount to the 401k. You have a finite amount lifetime tax-advantaged space and every year you miss is $17k less.
At least you have the income to pay off the loan in 9-10yrs. Just don't fail to give that a high priority.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Grt2bOutdoors »

I vote for Option A - place the full $17,000 in pre-tax deductions to the 401k account. You will receive a 40%+ upfront deduction, especially if you land in the dreaded land of AMT.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by hazlitt777 »

With a 7.6% guaranteed expense if you do not pay off the loans as soon as possible, and only a hypothetical higher return if you invest in stocks, bonds or gold, perhaps the best is to get the "guaranteed return" of 7.6% by paying off the loan first. Just a thought to ponder.

Also, perhaps you could go with just a 6 month or less emergency fund, to avail yourself of more money. Also, could your parents or friends loan you a few grand at say, 4%? Then they would get a better return on their cash, with you paying them back with monthly payments so they have a cash flow, and you would be paying 3.6% less. Let them be your bankers and it can be a win-win?
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by bungalow10 »

If your income is really high enough to put you in that tax bracket, then you should be able to get those loans paid off ASAP.

Our income is probably half yours, plus we have two kids in daycare, and my husband was laid off for awhile (so our income was probably 1/3 yours for a time being) - we managed to pay off 110k in two years, while still putting money in the 401k and making our 15 year mortgage payments and all the other stuff that goes with two kids and a mortgage and a 100 year old house.

Go scorched-earth on those loans and wipe them out in 2 years. THEN you will be truly well-to-do.

Keep in mind, that student loan interest isn't pre-tax - you make too much for that.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by rock_marmot3 »

Given your income level, I wonder if you're not missing the forest for the trees with this question. I obviously don't know the details of your budget, but it seems to me like you should be able to pay off the debt much sooner than 9-10 years and still continue to max out your 401k.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by bungalow10 »

rock_marmot3 wrote:Given your income level, I wonder if you're not missing the forest for the trees with this question. I obviously don't know the details of your budget, but it seems to me like you should be able to pay off the debt much sooner than 9-10 years and still continue to max out your 401k.
this x 10. There's no reason that debt should be around more than 2-3 years if their incomes are really what they allude to.
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Dandy
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Dandy »

Wow lots of debt and lots of income. I would put the overwhelming effort toward paying down those loans. If you can pay them off in close to 5 years you will be only 33 and with your income(s) be able to build a nice retirement nest egg. I hate student loans because they follow you until death - if you lose your job(s) you still have that debt.

If you want to start a family or buy a house it will be a real benefit to have that student loan debt off your back.

It is not a bad idea to invest some in retirement accounts so you start getting some experience/expertise and hopefully better returns that debt payoff. If it were me I would allocate 80% to debt reduction and 20% to savings.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Toons »

B) Put everything we can toward the loans and skip retirement contributions entirely until the loans are paid off, which I estimate we could do in about 5 years.

If I was in your shoes Plan B without a doubt,that's what I did,,,wow was I relieved when I had mortgage in hand,no regrets not one iota.If you follow that plan,and then get back to investing,,20 years from then you will be astounded at the growth of your capital ,having invested the "mortgage payment" if you do so :peace
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Cash
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Cash »

I was in a similar position to you a few years ago, but my wife and I started out with about half the amount loans. I'd go with option A. That said, I agree with others that you should be able to pay down your loans much more quickly than 9-10 years even if you're maxing out your 401k's and backdoor Roth IRAs.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by englishgirl »

Is there a 401k contribution level which will reduce your income enough to put you into the next lower tax bracket? If so, that could be a win-win.

What about fully funding traditional non-deductible IRAs? Then you could convert to Roth, depending on the tax situation. That would be a half way house between 401k and nothing, and would still contribute to growing your tax advantaged space. Doesn't reduce your current taxes any, though.

My preferred option is to live WAY below your means, and do everything: 401k, IRA and pay off the student loans. If your incomes are suitably high, why not? You don't have to buy matching beamers this year.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by NoVa Lurker »

Option A, no question.

And as others have said, it should not take you 9-10 years to knock out those loans. I owed just over $100k coming out of school, and I repaid all of it in less than three years, with a salary lower than yours.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Hector »

I would payoff student debt first.
Bob's not my name
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Bob's not my name »

You're getting these answers because your gross income has to be over $240,000 to put you in the 33% bracket, $274,000 if you max both 401k's.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Sammy_M »

market timer wrote:The 401K space is really valuable, but so is 7.8% tax-free. I'd suggest maxing out your 401K, then take out 401K loans to pay down your debt. It should take 3 years to pay off your debt, not 9.
I agree that this is a very smart approach that preserves the 401K space and allows you to pay down the high interest loan. As livesoft stated, 50% of balance, max $50K is the most you'll be able to take out in a loan from a single 401K though. If you leave the job you'll have to repay the loan immediately.
Also look into 0% APR credit card promotions to accelerate debt repayment
This is also good, but be very disciplined. Read the fine print regarding fees. NEVER miss a payment.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by madbrain »

With your income and the AMT issue, max the 401ks, no question .
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RolandTHTG
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by RolandTHTG »

Thank you everyone for the responses. I took another look at the numbers, and it turns out I screwed up the math pretty badly in my original post. I forgot to include the required minimum loan payments in the payoff calculations, and I was also incorrectly estimating our take-home pay for this year. After running the numbers again, we're looking at around 42 months to pay off the loans if we throw everything we have at them vs. 52 months if we max out both of our 401k's each year. Obviously that makes me feel a lot better about the decision either way. I don't think it makes a whole lot of sense to skip 3.5 years of retirement contributions just to pay off the loans 10 months early, so it looks like we'll be going with option A.

Again, thank you very much for all of your helpful advice.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by grabiner »

RolandTHTG wrote:Debt: My student loans are slightly over $150,000 all at fixed rates ranging from 5% to 7.8%, with a weighted average of 7.6%. Spouse's student loans are nearly identical, so a total of $300,000 between the two of us. No car loans, no credit card debt, and we rent, so no mortgage.

Tax Filing Status: Married filing Jointly

Tax Rate: 33% Federal 6% State (It looks like we'll also be subject to AMT in 2012.)
This means that your loan interest is not tax-deductible, so paying down those loans is a risk-free 7.6% return; $1000 used to pay down the loans now will save you $1340 in four years. $1000 can be used to put $1515 in the 401(k) (34% tax bracket, assuming AMT), and an investment of comparable risk would earn about 2% (Total Bond Market, yielding 2.19%, has a longer duration), so you will have $1640 in the 401(k).

So, would you rather have $1340 in taxable or $1640 in the 401(k) in four years? If you can max out your retirement savings every year (401(k), Roth IRA, 529 plans for any children you have later), then the 401(k) is probably better; you'll lose about the same amount to taxes on either account. If you have a future year in which you can't max out the 401(k) unless you have the $1340 in taxable, then you can convert the $1340 in taxable to $2040 in the 401(k), so even if you lose some of it to taxes along the way, you'll come out ahead by paying down the loans.

Thus, if you are sure you will be able to max out your tax-favored accounts every year for a long time, the four-year duration of the loans implies that it is better to keep them and pay them off over four years, but it's a relatively close decision. If one of you might want to take time off to raise children, I would go with paying down the loans.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by TheInsomniac »

Maybe I'm missing something here, but as far as I see it there are only four numbers you have to worry about*: the principal and interest rate of your loans, and the principal and rate of return of your investment (i.e., your 401k).

Your student loan interest is stated at 7.6%. The historical annual rate of return of the S&P500 is 9%; the average investor does worse than this return, and even with a stock index fund you'll have transaction fees. So let's say a good rate of return on your investments is the same as your student loan interest rate: 7.6%.

In order for it to make more sense to save for retirement than to pay off your loans, the principal on your investments would have to be more than the principal on your debt. In other words, at the present, you would need to have $300,000 in your 401k, today, in order to justify delaying loan payment.

If you make no loan payment at all this year (I know that can't happen), you will accrue well over $20,000 in interest on your loans this year. Even if you pay your loans down by 25% by year's end, you'll still accrue around $20,000 in interest. The interest burden alone is more than your entire 401k contribution for the year.

So, again, maybe I'm missing something, but I say pay those loans, and as fast as possible.

*I'm ignoring the tax bracket comments, because per your correction, this seems less relevant.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by TheEternalVortex »

Apparently you make at least $217,450. It seems like the $34,000 in 401k contributions shouldn't even really affect your pay that much, you'll still have a ton of money. I would max out the 401k first, just because you'll likely end up with not-enough tax-advantaged space in the future, but then you should still be able to pay off your loans in ~5 years-ish.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by Bob's not my name »

TheEternalVortex wrote:Apparently you make at least $217,450.
At least $240,000. Tax bracket is based on taxable income.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by grabiner »

TheInsomniac wrote:Maybe I'm missing something here, but as far as I see it there are only four numbers you have to worry about*: the principal and interest rate of your loans, and the principal and rate of return of your investment (i.e., your 401k).
The additional factor is the difference between taxable and tax-deferred investing. If the OP maxes out his 401(k), he will have a large 401(k). If he pays off his student loans before investing in the 401(k), he will have more money to invest once the student loans are gone, but he won't be able to add that extra money to the 401(k) because he is maxing out.

For most people who are considering paying off debt, this is not an issue; the question is whether to invest in a 401(k) this year, or pay down a loan and then use the reduced loan balance to invest in a 401(k) in a later year. In that situation, your simple comparison is correct: compare the interest rate of the loans to the interest rate of a comparable-risk investment (a bond with duration equal to the loan).
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by retiredjg »

Ordinarily, I'd say pay off the debts. But in your case, I think I'd build up the tax-advantaged space. You're going to need it later. I have to admit that it won't be a great deal in relation to what you ultimately save, but it is better than nothing.

Even if you max the 401ks, you are still putting a LOT of money toward the debts.

This is one of those decisions that cause people to have different opinions and different feelings. I'm not sure the financial answer is as important as how you feel about your decision.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by TheInsomniac »

grabiner wrote:
TheInsomniac wrote:Maybe I'm missing something here, but as far as I see it there are only four numbers you have to worry about*: the principal and interest rate of your loans, and the principal and rate of return of your investment (i.e., your 401k).
The additional factor is the difference between taxable and tax-deferred investing. If the OP maxes out his 401(k), he will have a large 401(k). If he pays off his student loans before investing in the 401(k), he will have more money to invest once the student loans are gone, but he won't be able to add that extra money to the 401(k) because he is maxing out.

For most people who are considering paying off debt, this is not an issue; the question is whether to invest in a 401(k) this year, or pay down a loan and then use the reduced loan balance to invest in a 401(k) in a later year. In that situation, your simple comparison is correct: compare the interest rate of the loans to the interest rate of a comparable-risk investment (a bond with duration equal to the loan).
OK, but I'm still failing to see how placing money in the 401k now is a better, i.e., more profitable, decision. I understand that 401k is tax-deferred, so one might shave a few percent off the annual tax bill by dropping a bracket. But how does it make sense, in numbers, to not pay off a huge principal debt ($300,000!), with a relatively high interest rate (7.6%), at least for loans.

This question is personal to me because I have my own loan debt to pay, though I'm lucky to have a far lower principal and a lower interest rate.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by grabiner »

TheInsomniac wrote:OK, but I'm still failing to see how placing money in the 401k now is a better, i.e., more profitable, decision. I understand that 401k is tax-deferred, so one might shave a few percent off the annual tax bill by dropping a bracket. But how does it make sense, in numbers, to not pay off a huge principal debt ($300,000!), with a relatively high interest rate (7.6%), at least for loans.
The missing issue is time. It's better to pay an extra 4% for five years in order to earn an extra 1% for 30 years. If the OP pays off his loans, he will have less in his 401(k) and more in his taxable account, and that will last for the rest of his working career; the taxes he pays on his taxable account will be more than the interest he saved by paying down the loans early.

And the reason that the time issue is short is that he has enough extra money to pay down the loans over five years even while maxing out the 401(k). If he didn't have that much spare money (as his original post suggested that it would take ten years to pay off the loans), then it would make more sense to pay down the loans first.
This question is personal to me because I have my own loan debt to pay, though I'm lucky to have a far lower principal and a lower interest rate.
Start another thread with your own numbers and we can give you more advice.
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by grabiner »

grabiner wrote:
TheInsomniac wrote:OK, but I'm still failing to see how placing money in the 401k now is a better, i.e., more profitable, decision. I understand that 401k is tax-deferred, so one might shave a few percent off the annual tax bill by dropping a bracket. But how does it make sense, in numbers, to not pay off a huge principal debt ($300,000!), with a relatively high interest rate (7.6%), at least for loans.
The missing issue is time. It's better to pay an extra 4% for five years in order to earn an extra 1% for 30 years. If the OP pays off his loans, he will have less in his 401(k) and more in his taxable account, and that will last for the rest of his working career; the taxes he pays on his taxable account will be more than the interest he saved by paying down the loans early.

And the reason that the time issue is short is that he has enough extra money to pay down the loans over five years even while maxing out the 401(k). If he didn't have that much spare money (as his original post suggested that it would take ten years to pay off the loans), then it would make more sense to pay down the loans first.
This question is personal to me because I have my own loan debt to pay, though I'm lucky to have a far lower principal and a lower interest rate.
Start another thread with your own numbers and we can give you more advice (or you can PM me if you don't want to make your details public, although my advice is not as good as the collective wisdom of the forum).
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Re: Paying Down 6-Figure Student Loans vs Investing in 401k

Post by market timer »

TheInsomniac wrote:
grabiner wrote:
TheInsomniac wrote:Maybe I'm missing something here, but as far as I see it there are only four numbers you have to worry about*: the principal and interest rate of your loans, and the principal and rate of return of your investment (i.e., your 401k).
The additional factor is the difference between taxable and tax-deferred investing. If the OP maxes out his 401(k), he will have a large 401(k). If he pays off his student loans before investing in the 401(k), he will have more money to invest once the student loans are gone, but he won't be able to add that extra money to the 401(k) because he is maxing out.

For most people who are considering paying off debt, this is not an issue; the question is whether to invest in a 401(k) this year, or pay down a loan and then use the reduced loan balance to invest in a 401(k) in a later year. In that situation, your simple comparison is correct: compare the interest rate of the loans to the interest rate of a comparable-risk investment (a bond with duration equal to the loan).
OK, but I'm still failing to see how placing money in the 401k now is a better, i.e., more profitable, decision. I understand that 401k is tax-deferred, so one might shave a few percent off the annual tax bill by dropping a bracket. But how does it make sense, in numbers, to not pay off a huge principal debt ($300,000!), with a relatively high interest rate (7.6%), at least for loans.

This question is personal to me because I have my own loan debt to pay, though I'm lucky to have a far lower principal and a lower interest rate.
Think of it just in marginal terms, not in terms the whole balance, which may be causing confusion. Is it better to put $100 pre-tax into a 401K or receive that money after-tax, about $60, and use that $60 to pay down debt? Let's use whole numbers and suppose the 401K balance will grow at 2%/year risk-free, while the loans are at 8%. Also, based on expected future tax rates, this person values $1 pre-tax in a 401K as worth $1 outside the 401K in a taxable account.

The answer to the question depends on how long it will take to pay down the debt (t years).

After t years, $100 in a 401K grows to $100*(1.02)^t. The $60 loan balance grows to $60*(1.08)^t. Around 9 years, both balances grow to $119; before 9 years, the 401K is preferred; after 9 years, loan prepayment is preferred. So, the answer to the question really depends on how long it takes to pay down those high interest loans. In this example, with whole numbers pretty close to those in the OP, the 401K is preferable whenever it takes less than 9 years to pay off the high interest loans.

One final point: this analysis assumes no 401K loans are possible. If a 401K loan is permitted, then the breakeven point is pushed much further into the future, since 401K contributions barely slow down loan prepayment (i.e., contributing $100 and borrowing $50 allows one to pay down almost as quickly as paying $40 in taxes and paying down $60).
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