Expert: Gina Boykin - 12/19/2007

Question
Hi, I'm a junior in college and have relatives that are going to give me some
money when I graduate (about $6,000).  I already have an emergency fund
built up.  So what would be a better goal for this money: paying off student
loans (which are subsidized with the  low interest rates) or placing it in a
retirement account (either a traditional or a Roth IRA)? Or both?
  Thanks for your help,  Noah

Answer
The answer depends on what is more valuable to you - being debt free or investing for retirement.  There are financial experts that can argue the benefits of each, but I think that your values should determine what you do.  It also depends on how soon you will pay the loans off if you don't use the money you receive as this gift.  If you can pay the loans off in the next couple of years, it may not be be a big difference (in interest) to just place the money in a Roth IRA.  However, I would not use the money for a Roth and then take 10 years to pay off your student loans.

The Roth IRA is a better choice than the traditional IRA.  The Roth IRA gives you tax-free earnings when you start to withdraw money in retirement, in exchange for using after-tax money for your contributions.  A traditional IRA gives you a tax benefit now, in exchange for paying taxes on your earnings when you retire (tax-deferred).  If you put $6,000 in a retirement account that gives you an average of 10percent a year, and don't touch it for the next 40 years, your account will grow to $271,000.  So, with the Roth, you didn't get a tax benefit on the $6,000 but you don't have to pay taxes on the $271,000 as you withdraw it.  Would you rather pay taxes on $6,000 now or $271,000 later?  Exactly!

Keep in mind that the limit for Roth contributions is $4,000 in 2007 and $5,000 in 2008.  So, even if you decide to invest in a Roth, you will still have some money left over to pay down your student loan.