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A financial compromise

Chris Farrell Apr 26, 2010

Question: My husband and I save approximately $2500 a month of our combined income. We both also contribute to 401Ks that are matched by our employers. Aside from a mortgage and a $40,000 student loan, we have no debt and a health emergency savings account. My question is, should we be paying off this student loan as quickly as possible? Or should we be investing half of our monthly savings in an index fund or something else for future use? Thank you so much for this program! We’ve learned so much! Jennifer, Apple Valley, MN

Answer: Sad to say, compromise is a word that has fallen into disrepute in recent years. (james Madison would be appalled.) But when it comes to finance and questions like yours I lean toward, yes, compromise.

Specifically, I would put a hefty percentage of your monthly savings toward student loan debt. It will lower the overall cost of your education. But I’d also consider investing some of the money into a diversified long-term portfolio held in taxable accounts. Yes, you’ll pay taxes on dividends, realized capital gains, and interest payments along the way. But the big advantage of creating a long-term savings portfolio in taxable accounts is flexibility. For example, if you pull money out of a 401(k) you’ll pay a 10% penalty plus your ordinary income tax rate on the withdrawal. You could borrow from the plan, but that maneuver reduces the long-term return on retirement savings.

Now, I know you have a good savings buffer. Yet with a taxable account you let the money grow for a long period of time and tap when you want without penalty. You will pay Uncle Sam a long-term capital gains tax rate when you cash it in–assuming you’ve owned the investment for more than a year–but it’s still at a lower rate than ordinary income tax rates.

Another benefit to investing in taxable accounts is tax diversification. For example, in the early yeras of retirement it is sometimes tax smart to leave tax-sheltered savings alone and tap into taxable accounts.

So, I’d play with the numbers. Perhaps you could put two-thirds of the money toward the student loans and one-third into long-term savings? 80% and 20%? A 50/50 split? Whatever works for you?

One other thought: Would change this calculation is if the student loan debt is at a very high rate, say, 8% to 9%. At that point the return on investment for paying it down–8% to 9%–is so high that I’d put everything into paying off the loans. But if the interest rate is at a lower rate than that I would consider a program of both aggressive debt reduction and boosting long-term savings.

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