Ric Edelman is a co-founder of Edelman Financial Engines. The following is taken from his weekly radio call-in show.
It’s never too early to prepare for retirement.
Question: My 26-year-old nephew lives with his parents and is working at his first serious job since graduating from college. He grosses about $50,000 a year and has $15,000 in the bank. He pays about $2,500 a year in interest on student loan debt of about $82,000. His loans are made up of components with interest rates that vary from 3.25% to 8%. I pointed out to him that if he makes a traditional IRA contribution he will increase his tax refund by about $1,100. Or he could contribute the maximum to a Roth IRA and let it grow 40 or 50 years tax-free. The third option would be to apply that money toward the student debt. His parents and I would like your opinion on which is his best option.
Ric: None of the ideas you mention is a bad one.
I would recommend that he contribute to a Deductible IRA. I question whether the Roth IRA will be tax-free by the time he’s in his 70s. That’s 50 years from now — 25 Congresses and maybe six presidents into the future.
Can we really predict how they will treat the Roth IRA? You don’t have to worry or wonder with the Deductible IRA, because he gets the tax break this year (instead of merely the promise of getting a break some 50 years from now).
However, even after making that contribution, he still has extra money. So I would use it to pay down the 8% college debt. He should not be in a hurry to pay down the portion of the debt that’s costing him only 3.25%. (That rate is so low he can likely earn more through a diversified portfolio over the next few decades.)
If he is not permitted to apply his payments only to the higher interest portion of the debt but is instead required to apply the extra payments across all the loans, then I wouldn’t prepay at all. Instead, he should place all his savings into a diversified investment portfolio.