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IRA vs student loan

Question: I am self employed, and have a mountain of high interest (above 7%) private student loan debt (approx. $55K). I also have federal student loan debt, but that is not much of a concern, as the interest rate is very low around 2%. Each year around tax time I contribute the max to a traditional IRA, which I believe this year is $5000 again. Most of my private student loans are from law school, but I have one lingering from undergrad on which I only owe about $4500. I am wondering if it is wise to just skip the IRA contribution this year, and pay off that loan. I've been paying about $200-$300 on this loan for 12 years now! (It was only about $15k to begin with). Is it wise to just pay off this loan and feel good that I have one less payment every month, and then I can contribute that money to another private loan, or is it smarter to make the IRA contribution, not only for the long term savings, but also for the tax deduction? Thanks very much for your advice. Heather, Oakland, CA

Answer: Yes, the maximum is $5,000 this year for an IRA contribution. (By the way, you could put away more if you wanted to in a SEP-IRA; it's a very simple, low cost retirement savings option for the self-employed.)

Now, I usually lean toward continuing IRA contributions. But in your case I think you should get rid of the loan from your undergraduate days. For one thing, you've already demonstrated that you can save for retirement. The money you've already put into the tax-sheltered IRA will keep on compounding over time. For another, when you're trying to reduce large debts it's always a real psychological boost to successfully get rid of a loan. Its concrete evidence that that your efforts are paying off.

One other thought: A 7% private student loan is expensive. You'll earn a 7% return on your money by paying it down. So, next year how about getting more aggressive with the student loan debt but still contribute some money into the IRA. Perhaps you won't be able to make a maximum contribution (although we can hope that your business does so well that you can). But you'll be adding some new money into your retirement account.

About the author

Chris Farrell is the economics editor of Marketplace Money.
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I appreciate this great answer as this situation applies to me too - BUT I also have some credit card debt at a 9.9 interest rate AND a federal tax debt of 11K. Any further advice? I am currently contributing about 4 % to my deferred comp and paying down the debts at 650 per month on the law school student loans (CONSOLODIATED - 10 yrs left) and 750 a month on the credit card debt. I also have a car payment and recently sold my house on a short sale so no interest write off (hence the tax debt). HELP!!! My tax rate is KILLING ME.

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