Financial Priorities for New Entrants to the Workforce

  • Students entering the workforce tend to have high expenses and relatively modest income.
  • Young adults need to prioritize the establishment of a good credit rating, the creation of an emergency fund, and investments in their job search.  
  • Contributions to 401(k) plans can wait.
  • A strategy of rapid reduction of student debt immediately upon entering the workforce will substantially improve credit scores and borrowing costs and reduce lifetime student loan repayments, by tens of thousands of dollars.   
  • Student borrowers with low-cost federal loans and higher cost private loans should prioritize repayment of the high-cost loan. It may be possible to refinance the federal debt once the private loan is eliminated, further reducing lifetime student loan payments.
  • The rapid repayment of student loan debt can lead to increased contributions to retirement plans once some or all student debt is eliminated.

Many financial planners and firms with solid reputations urge new entrants to the workforce to start their career by aggressively contributing to their 401(k) plan and saving for retirement.  Fidelity, a leading investment firm, recommends young adults have a 401(k) balance equal to their annual salary by the time they are 30.  

My view is that this objective is unrealistic for the vast majority of young adults entering the workforce with limited liquidity and substantial debt.  

My financial advice to young adults entering the workforce can be summarized in three tips – (1) maintain a solid credit rating, (2) create an emergency fund, and (3) rapidly reduce student debt to a manageable level.   The achievement of these goals often requires that student borrowers entering the workforce either entirely forego contributions to their 401(k) plan during their first few years in the workforce or at least substantially reduce contributions for some time.  

The importance of an emergency fund and a solid credit rating:

The first few years after a person completes school and starts a career are often financially challenging.  People leaving school often starts their job search with limited funds in the bank.  Starting salaries are often lower than expected and relatively few students immediately get their dream job. The process of searching for a good job is expensive and time consuming.  The successful job candidate often has some moving expenses.

Student debt repayment obligations generally start 9 months after full-time student status ends.  Moreover, the proportion of students with subsidized federal loans has fallen. The increased use of unsubsidized federal loans and private student loans has increased interest costs on student debt early in the borrower’s career. 

Contributions to a 401(k) plan should be an extremely low priority for a person starting a career with a low starting salary, in full search mode for a better job, without substantial savings and with immediate student debt obligations.

The financial planner will tell the financially strapped person with no funds to take the employer match on 401(k) contributions because it is “free money.”  Employer matches to 401(k) contributions are not free money if the diversion of money from current needs results in late payments and a deterioration of the person’s credit rating

The highest, perhaps only, financial priority of the new entrant into the workforce is to build a financial buffer in order to maintain a solid credit rating.

The failure to maintain a good credit rating will lead to extremely high costs for borrowers.

A search was conducted for likely interest rates for good and poor credit risks for four different types of loans – (1) credit card loans, (2) car loans, (3) a private student loan, and (4) a mortgage.  Assumptions were made on the likely maturity and initial balance of each loan and these assumptions were used to generate estimates of the monthly cost of bad credit.

The interest rate assumption was obtained from WalletHub, the car loan assumption was obtained from Nerd Wallet, the private student loan assumption was obtained from Investopedia, and the mortgage rate assumption was obtained from this CNBC article. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.

The cost of bad credit depended on both the interest rate differential and the likely loan amount.  The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.

The analysis assumed the borrower only paid interest on credit card debt.   Assumed maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.

Based on these assumptions, I found the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.

The figures presented here show bad credit ratings can lead to substantial costs with costs depending on both interest differential and loan amounts.  The interest differential stemming from credit ratings is highest for credit card loans and private student loans.  

The payment differential associated with credit ratings is often highest for mortgage debt because mortgage loans are large. In today’s housing market with soaring home prices and tighter lending standards it is very difficult to purchase a home without good credit.

The cost of bad credit is not limited to one or even a few loans.   Most people take out multiple consumer loans or mortgages in their lifetime.  The lifetime cost of bad credit will be substantial for households that do not improve their credit rating. 

Poor credit ratings have other adverse impacts in addition to higher loan costs.   The Insurance Information Institute points out the insurance companies use credit ratings to set insurance premiums because actuarial studies have shown that credit scores are good predictors of the tendency for people to make insurance claims.  The credit rating agency Experian points out that employers can and sometimes do base hiring decisions on an applicant’s credit history.   Landlords use credit ratings to determine eligibility for an apartment.

The Importance of Rapid Student Debt Reductions Early in a Career:

Students leaving school with substantial federal and private student debt should rapidly repay the private student loan even if the rapid repayment of the private loan causes them to forego contributions to their 401(k) plan.

The rapid reduction after joining the workforce will drastically reduce lifetime student debt borrowing costs.   Rapid debt reduction may make it possible for the student borrower to refinance remaining debt at a lower interest.

Finance companies often attempt to persuade student borrowers to refinance their federal student loans to lower-interest rate private loans.   This article provides recommendations from CNBC on the best companies for refinancing student debt. 

Often student borrowers cannot refinance to a substantially lower interest rate immediately upon graduation because their work and credit history is short, and their initial salary is low.  A student borrower could improve their credit report by foregoing 401(k) contributions for a year or two and then refinance the remaining student loan at a lower interest rate.

There are advantages and disadvantages associated with refinancing federal loans to private loans.  The primary advantage is a lower interest rate, perhaps as low as 3.0%.  You must be careful when refinancing a fixed rate student loan to a variable rate loan because the student loan interest rate can rise substantially if Treasury rates rise.   In addition, the decision to refinance with a private student loan makes the borrower ineligible for forbearances in case of economic hardship and makes the borrower ineligible for income driven loan programs 

The potential financial gains from a strategy of rapidly reducing student debt upon entering the workforce are examined for two student borrowers – one with a large federal undergraduate loan and the other with a mix of federal undergraduate and graduate loans and a private loan.

Student Borrower Number One:   The first student borrow is starting her career with a $50,000 per year job and undergraduate student loans totally $30,000 with an interest rate of 5.05% around the 2019 average student debt level for undergraduates.   

A person in this situation will typically take out a 20-year student loan.   Her payments on the loan will $198.82 per month.  Her total payment over 20 years will be $47,716.   

The person could more rapidly repay her student loan if she foregoes contribution to her 401(k) plan.   Assume she currently pays 10 percent of her income to her 401(k) plan.  If she foregoes this contribution her annual income tax will increase by $600.  However, she could increase payments on her 401(k) plan by $4,400 per year to a total monthly payment of $565.48. 

Under this assumption the student borrower would totally repay her $30,000 student loan on the 61stpayment.   Her total student loan repayment costs would be $33,837, a savings of $13,879.

The strategy of rapidly repaying the student loan causes the student borrower to fall behind on her accumulation of 401(k) wealth.  However, her student loan is totally paid off after 61 months and she could now make larger 401(k) contributions than the person who immediately initiated 401(k) contributions after leaving school.

The student borrower in this example could forego 401(k) contributions and make monthly payments of $565.48 for two years and then attempt to refinance the loan at a lower interest rate for a 10-year period.

The outstanding balance after two years of payments would be $18,932.

The person after reducing the loan balance that quickly might be able to refinance at a 3.0% interest rate.  The total student debt payments from this strategy, rapid repayment for two years followed by a 10-year loan at 3.0%, is $35,509 or $12,207 less than under a 20-year term.

The rapid reduction of student debt will lower the probability the person experiences debt payment problems and will substantially reduce expenditures on student debt.   

The results are even more dramatic for a student borrow that has a combination of federal debt and high-rate private loans.

Student Borrower Number Two:   The second borrower has three student loans, a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00%.    Intuitively, it makes sense for this student borrower to prioritize rapid repayment of the higher interest rate private loan.  In most instances, the strategy of rapidly repaying the private student loan necessitates the borrower forgoing contributions to a 401(k) plan early in her career.

The student borrower who chooses to set the standard 20-year maturity on all three student loans has a monthly payment of $775 for 20 years leading to total student loan payments of $200,633 over 20 years.

The student borrower who chooses to set the standard 20-year maturity for the federal undergraduate and the federal graduate loan and set a 5-year term for the private loan will initially have monthly student loan payments of $1,065.   

The monthly payment will fall to $534 after the private student loan is totally repaid, which is lower than the $775 payment that exists if the person kept to a 20-year term on all loans.  This means the person who chose the rapid private student loan repayment strategy could after 5 years make larger 401(k) contributions for the next 15 years than the person who chose a 20-year private loan term.

The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years is $146,271, which is a total lifetime savings of $54,362. 

This student borrower is in a good position to refinance her federal student debt to a private lower interest rate loan after repaying her private loan.  The cost savings estimates presented here may understate potential benefits from a strategy of rapidly reducing private student debt.

Concluding Thoughts:  The student borrower entering the workforce is often under intense pressure from financial advisors to immediately contribute part of their salary to a retirement account.  This approach can lead to financial disaster.   

The young adult with a modest salary and high student debt payments who prioritizes saving for retirement can fall behind on her bills, which can lead to poor credit ratings.   The deterioration in credit ratings will lead to high borrowing costs and other problems including difficulties renting an apartment, loss of job offers and higher insurance costs.  

Eventually, many people who choose to aggressively save for retirement will raid their 401(k) and maybe even sometimes pay taxes and penalties.  Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan   

The wiser course of action for young adults entering the workforce saddled with student debt is to rapidly repay student loans, especially but not exclusively high-cost private loans.  This approach will secure a solid credit rating and will reduce lifetime student loan payments by tens of thousands of dollars.

This post is part of a series comparing the traditional financial plan, stressing 401(k) investments and house purchases with 30-year mortgages to an alternative financial plan, which prioritized debt reduction, use of Roth accounts and use of 15-year mortgages.   The first post provided an overview of the alternative financial plan.  The next post, available in a week or so, will look at some problems with conventional retirement accounts starting with high fees on some plans.

Should you invest in a 401(k) plan, an IRA, or both?

Financial Tips:   When should a person use an Individual Retirement Account rather than a 401(k) plan?   When should a person leaving an employer convert her 401(k) plan into an IRA?

Analysis:

Most financial advisors believe that workers saving for retirement should invest in a 401(k). rather than an IRA.  Many government rules favor 401(k) contributions over iRA contributions.  First, employee contribution limits for 401(k) plans are around 3 times higher than limits for IRAs.  Second employees are allowed to make additional contributions to 401(k) plans but are not allowed to make similar contributions to IRAs.  Third, many employers routinely match employee contributions.   Fourth, the IRS imposes limits on deductibility of some iRAs but not the deductibility of 401(k) plans.   Fifth, the IRS restricts Roth IRA contributions for higher income households but does not restrict contributions to Roth 401(k) plans.   

IRS rules allow 401(k) plans to automatically enroll workers who do not opt out.  However, there are situations where people are better off investing in an IRA separate from their employer than in the firm 401(k) plan. 

The main factor favoring IRAs over 401(k) plans is the higher administrative costs of 401(k) plans.  Fees on 401(k) plans are applied to the entire 401(k) balance and are often between 1 percent or 2 percent per year.  These fees can substantially erode a workers 401(k) balance over the course of the workers lifetime. 

High 401(k) fees are more prevalent at small firms than large firms. People working at a firm offering a plan charging high 401k) fees and offering little or no employer contributions need to look at other investment options than their 401(k) plan. High 401(k) fees can substantially erode retirement savings.   These fees can largely be avoided by using an IRA rather than a 401(k) plan to save for retirement.

I constructed a spreadsheet to estimate the impact of high 401(k) fees at retirement savings.   The assumptions in a baseline analysis involved a person with a starting salary of $50,000 who works for 35 years and realizes wage growth of 2% per year over her entire career.  This person contributes 10 percent of her salary to a 401(k) plan and earns an annual return of 7%.

When fees are 2 percent of the end-of-year 401(k) balance the total fees over the entire 35-year career are slightly more than $153 k compared to an ending balance of slightly less than $600 k.   

By contrast, when 401(k) fees are 0.5 % (a reasonable fee structure that exists at many firms) total fees over the 30-year career are around $48 k and the ending balance is around $830 k.

Note the difference between ending balances of the two scenarios is much larger than the difference in fees because additional 401(k) income from the lower fee compounds at the average rate of 7 percent per year.

One possible strategy for a worker at a firm that match some employee 401(k) contributions is to make a small contribution to the 401(k) to take advantage of the employer match and then invest additional funds in an IRA. This strategy may or may not be feasible depending on IRS rules governing IRA contributions, deductibility of IRA contributions, and the individual’s household Adjusted Gross Income.

The 401(k) fees are applied to all assets in the 401(k) plan.   In the current low interest rate environment, the expected return on government bonds adjusted for 401(k) fees is negative.   In this circumstance, it may make sense to place more 401(k) funds in equity and accumulate debt investments outside of a 401(k) account where they are not subject to 401(k) fees.  One alternative, which many people overlook, is direct investment in Treasury bonds and bill at Treasury Direct.

https://www.treasurydirect.gov.

Firms like Fidelity, Schwab, and Vanguard aggressively ask people who leave their employer to convert their 401(k) plan to an IRA.   This is the rare case where aggressive solicitation from financial firms is actually sound advice.  Fees on well-designed IRAs are often near 0.2%.  The decision to maintain funds in a dormant high-fee 401(k) plan could lead to a substantial loss in retirement savings.

One of the key selling points of conventional 401(k) plans is the ability of these plans to reduce current year tax obligations.   By contrast, Roth 401(k) plans and Roth IRAs do not reduce current year tax obligation but do reduce taxes in retirement.  A person with low current year tax obligations and the ability to reduce taxes through other means such as contributing to health savings account may choose to reduce or eliminate contributions to a conventional 401(k) plan.   This person might instead invest through a Roth 401(k) plan if available at her firm or through a Roth IRA.  The lack of a Roth 401(k) option may lead some investors who are concerned about tax obligation in retirement to consider a Roth IRA over a conventional 401(k) plan.

The issue of deciding between a 401(k) plan and an IRA is related to several other issues including – the choice between debt reduction and mortgage savings, the choice between investing in a health savings account or a retirement account, and the choice between a conventional and Roth IRA.    Other financial tips on these related issues will follow shortly.