brianbooth wrote:Hi Ron,
I'm just heading out to lunch so can't run too many numbers but here are my initial thoughts:
1. With your nasty tax-bracket, the after-tax rate on your 8.5% student loan is only 5.1%, assuming that the interest is deductible from CA income taxes?
Seriously. The good news is that the interest on the first $37,000 of your $200,000 of debt would be deductible if you weren't way, way over the income limit and if the student loan interest deduction as such weren't expiring in eleven days.countofmc wrote:This is incorrect as the max amount you can deduct is $2500. Plus your MAGI has to be lower than $75000 or thereabouts, so OP might make too much money to deduct even that.brianbooth wrote:Hi Ron,
I'm just heading out to lunch so can't run too many numbers but here are my initial thoughts:
1. With your nasty tax-bracket, the after-tax rate on your 8.5% student loan is only 5.1%, assuming that the interest is deductible from CA income taxes?
grap0013 wrote:Also, do remember, you deduct 401K contributions at your marginal rate, but upon withdrawal, you fill up lower tax brackets first, making the average rate much lower. This is one of the greatest tax arbitrage opportunities few understand very well outside this website.
grap
DTSC wrote:I would pay off the debt. There is significant psychological benefits to doing so
market timer wrote:Answer depends on how much you save per year and what your expected tax rate on withdrawals will be. Someone who will be able to withdraw tax-free from the 401K and who can expect to pay off the 8.5% interest loans in the next several years should max out the 401K. Someone else who doesn't save enough to max out the 401K in a typical year should probably just focus on debt repayment. One way around this dilemma is to max out the 401K and then take a 401K loan to pay down your loans. Then you get your tax deduction without slowing down student loan repayment.
ronima wrote:Math Question: How can I relate my 8.5% debt to a pre-tax 401(k) investment so that I can compare numbers?
- the 8.5% debt is, worst case, 25 years in repayment. Compounding can be avoided if I do my paperwork right...I think.
- I understand that I can translate debt repayment into a bond equivalent for math purposes.
- I still don't understand how to compare this to a similar pre-tax (40% savings in my case) equivalent investment, assuming the 25 year worst-case scenario (and I can't figure out intermediate scenarios either).
grabiner wrote:This is a 17% gain, or 0.52% annualized; thus, if you invest the 401(k) in bonds earning 3%, you will earn 3.52%.
There is one additional issue: if you don't max out your 401(k) now, then you may have to make taxable investments later, and thus you will lose the benefit of some of the tax deferral. However, with a rate as high as 8.5%, the benefit of tax deferral isn't worth the difference.
grap0013 wrote:I see you are in a pretty high tax bracket and your monthly expenses are low. I would max 401K/Roth IRA and put extra cash flow on loans. Increase emergency fund to ~2 years. Should be easy with your income and expenses. Then borrow from 401K to pay off a chunk of loans. Treat 401K loan like a bond. This also increases tax deferred space since interest is paid directly to you. Once you miss a year of tax deferred space you never get it back.
Also, do remember, you deduct 401K contributions at your marginal rate, but upon withdrawal, you fill up lower tax brackets first, making the average rate much lower. This is one of the greatest tax arbitrage opportunities few understand very well outside this website.
grap
grabiner wrote:ronima wrote:Math Question: How can I relate my 8.5% debt to a pre-tax 401(k) investment so that I can compare numbers?
- the 8.5% debt is, worst case, 25 years in repayment. Compounding can be avoided if I do my paperwork right...I think.
- I understand that I can translate debt repayment into a bond equivalent for math purposes.
- I still don't understand how to compare this to a similar pre-tax (40% savings in my case) equivalent investment, assuming the 25 year worst-case scenario (and I can't figure out intermediate scenarios either).
Adjust the return for the difference in tax rates. If you retire in a 40% tax bracket, and will withdraw the money 30 years later in a 30% tax bracket, then it costs you $6000 to put $10,000 in the 401(k), and you will get the future value of $7000 out. This is a 17% gain, or 0.52% annualized; thus, if you invest the 401(k) in bonds earning 3%, you will earn 3.52%.
There is one additional issue: if you don't max out your 401(k) now, then you may have to make taxable investments later, and thus you will lose the benefit of some of the tax deferral. However, with a rate as high as 8.5%, the benefit of tax deferral isn't worth the difference.
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