Second Best Investment
companies offer 401(k) or similar retirement
plans to their employees, and an employer
match might be available. If that's the
case, you should contribute to the plan
at least enough to get the full match.
1: Melissa North earns $80,000 a year.
Her company's 401(k) plan offers a full
match for up to 6% of salary. Therefore,
Melissa should contribute at least $4,800
(6% of $80,000) to her 401(k) account
this year, which will entitle her to a
$4,800 company match.
you're offered a full or partial match,
you should contribute at least enough
to get all the dollars your company offers.
Failing to get the maximum match means
you're giving up free money: relinquishing
part of your compensation package.
your employer match is a no-risk way to
earn a 100% return (or a lesser return,
with a partial match) on your money. If
that's often someone's best investment
move, paying down debt may be next best.
When you reduce a loan balance and thus
reduce the interest you're paying, you're
effectively earning the loan interest
2: Owen Palmer has a credit card that
charges 12% on unpaid balances. When Owen
prepays $1,000 of his balance, he saves
$120 (12% of $1,000) in interest that
year. That's a 12% return on his outlay.
What's more, credit card interest typically
is not tax deductible. Thus, Owen earns
12%, after tax, by prepaying his loan.
possible that Owen could receive a higher
return by doing something else with his
$1,000, but that probably would mean taking
substantial risk. Prepaying debt, conversely,
has no investment risk beyond forgoing
the chance for a higher return. In today's
low-yield environment, prepaying debt
can be appealing.
credit card debt may be attractive for
many people, but prepaying student loans
can be a tougher call. Interest rates
may be lower than on credit card debt,
so the benefit of prepaying is not as
great. What's more, up to $2,500 of interest
on student loan debt is tax deductible
each year. To get the maximum deduction,
your modified adjusted gross income (MAGI)
can be no more than $65,000, or $130,000
on a joint return. Partial deductions
are allowed with MAGI up to $80,000 or
interest is tax deductible, the benefit
of prepaying the loan is reduced.
3: Rita Simmons has outstanding student
loans with a 7% interest rate. This year,
she expects to fall in the 25% federal
tax bracket, so paying the interest actually
saves het 1.75% (25% of 7%) in tax. Thus,
Rita's net interest rate cost for her
student loans is 5.25%: the 7% she pays
minus the 1.75% she saves in tax.
her situation, Rita would earn 5.25%,
after tax, by prepaying her student loans.
That could be a good move, for an outlay
without investment risk, but it's also
possible that Rita could earn more by
investing elsewhere. Moreover, Rita would
have to relinquish liquid assets by prepaying,
and replacing those assets in case of
an emergency might not be simple.
a home mortgage may be even less beneficial
than prepaying student loans. Assuming
a 4% interest rate and a 25% tax rate,
the after tax benefit of prepaying would
be only 3%. Although virtually all homeowners
can deduct mortgage interest, the net
payoff is oven smaller for taxpayers with
tax rates higher than 25%.
bottom line is that prepaying a loan makes
the most financial sense with high interest
rates and low tax benefits. State income
tax also should be considered. Our office
can help you calculate the true return
of debt prepayments, so you can make informed
August 2016 AICPA Client Bulletin