You've got extra money each month. Should it go toward crushing your student loans or building wealth in your 401(k)? This question haunts millions of millennials and Gen Zers.
The frustrating truth: there's no universal right answer. But there IS a right answer for YOUR situation. Here's how to find it.
The Quick Decision Framework
Before diving into details, here's the shortcut:
- Always get your full employer 401(k) match—it's free money
- Compare your student loan interest rate to expected investment returns
- Consider the guaranteed return of debt payoff vs. uncertain investment returns
Step 1: Capture the Full Employer Match (Non-Negotiable)
If your employer offers a 401(k) match, contribute enough to get the full match before doing ANYTHING else with extra money.
Example: Your employer matches 50% of contributions up to 6% of salary. You earn $60,000.
- Contribute 6% ($3,600/year)
- Employer adds $1,800 (50% match)
- That's an instant 50% return on your money
No student loan payoff strategy beats a guaranteed 50-100% instant return. Get the match first. Period.
Step 2: Compare the Numbers
After capturing your match, compare your student loan interest rate to expected investment returns:
If Student Loan Interest Rate > 7%
Priority: Pay off student loans aggressively
Historical stock market returns average about 7% after inflation. If your loans charge more than 7%, paying them off is essentially earning a guaranteed return higher than the market's historical average.
Private student loans and older federal loans often fall in this category.
If Student Loan Interest Rate is 5-7%
Priority: Split between both
This is the gray zone. A reasonable approach: contribute to your 401(k) beyond the match while making extra loan payments. You're diversifying your financial progress.
If Student Loan Interest Rate < 5%
Priority: Invest more in 401(k)
Many current federal student loans have rates between 3-5%. With expected investment returns of 7%+, the math favors investing—especially given the tax advantages of a 401(k).
The Tax Factor
401(k) contributions have significant tax advantages that change the math:
Traditional 401(k):
- Contributions reduce your taxable income today
- If you're in the 22% tax bracket, a $1,000 contribution only "costs" you $780 in take-home pay
- Money grows tax-deferred until withdrawal
Student Loan Interest Deduction:
- Can deduct up to $2,500 in interest annually
- But phases out at higher incomes ($75,000+ single)
- Less valuable than the 401(k) tax break for most people
Factor in your marginal tax rate when comparing options. The 401(k) often wins on taxes alone.
The Psychological Factor
Math isn't everything. Consider your mental relationship with debt:
Debt Anxiety High? There's value in the peace of mind from becoming debt-free. If student loans keep you up at night, prioritizing payoff might be worth the potential opportunity cost.
Comfortable with Debt? If you view low-interest debt as a tool and sleep fine knowing it exists, you can optimize purely on numbers.
Neither approach is wrong—just be honest about which camp you're in.
Special Situations
Public Service Loan Forgiveness (PSLF)
If you're working toward PSLF, the calculus completely changes. You want to minimize payments (income-driven repayment) while maximizing forgiveness. In this case, invest aggressively in your 401(k) and let the loans ride until forgiveness.
Income-Driven Repayment Forgiveness
If you'll receive forgiveness after 20-25 years on IDR plans, the forgiven amount is currently taxable (unlike PSLF). Factor in the tax bomb when deciding. Often, still better to invest—but run the numbers.
Refinancing Opportunity
If you can refinance from 7% to 4%, the equation flips toward investing. But: refinancing federal loans eliminates protections (IDR plans, forbearance, forgiveness). Only refinance if you have stable income and won't need those safety nets.
The Optimal Strategy for Most People
Given typical situations, here's a sensible order of operations:
- Contribute to 401(k) up to full employer match
- Build a $1,000 emergency fund
- If loan interest > 7%: Aggressively pay down loans
- If loan interest < 5%: Increase 401(k) contributions (aim for 15% of income including match)
- If loan interest 5-7%: Split extra money 50/50
- Build full emergency fund (3-6 months expenses)
- Once loans paid/401(k) on track: Max out 401(k) and consider Roth IRA
Running Your Own Numbers
Here's a simple comparison for $500/month extra:
Scenario A: Extra $500/month toward loans (6% interest, $30,000 balance)
- Loans paid off: 4 years instead of 10
- Interest saved: ~$5,500
- Then invest: 6 years at $500/month = ~$52,000 at retirement (assuming 7% return, 30 years total)
Scenario B: Extra $500/month to 401(k) (minimum payments on loans)
- Loans paid off: 10 years (standard repayment)
- Total interest paid: ~$10,000
- 401(k) after 30 years: ~$567,000 (7% return)
In this example, investing wins—but the 6% interest rate is key. At 8%, the math shifts toward loan payoff.
Frequently Asked Questions
What about Roth IRA vs. student loans?
Same framework applies. Roth IRA lacks the employer match advantage, so loan payoff becomes more competitive. But Roth's tax-free growth is powerful—consider splitting contributions if rates are moderate.
Should I pause retirement contributions entirely to pay off loans?
Almost never—especially if you have an employer match. The compound growth you lose by pausing contributions in your 20s and 30s is enormous. At minimum, capture the match.
What if my income is too high for student loan interest deduction?
This actually pushes the math slightly toward investing, since you're not getting the loan interest tax benefit anyway.
The Bottom Line
For most people with average student loan rates (5-7%):
- Get the full 401(k) match (always)
- Build a small emergency fund
- Split extra money between loans and additional 401(k) contributions
- Don't let perfect be the enemy of good—both paths build wealth
The most important thing? Pick a strategy and execute consistently. Either path beats financial paralysis.
