A client recently asked me in what order he should contribute to investment accounts. While I’m not allowed to provide specific investment advice per regulations, I can make you aware of rules that even most fiduciary fee-only financial planners don’t understand.
When you discover how the hidden 401k match works with tax-efficient investing with student loans, you’re going to want to contribute every dollar you can to your pretax retirement accounts.
The Best 401k Match is for Borrowers Planning on PSLF
If you plan to receive tax-free loan forgiveness, you want to pay the minimum on your student loans. However, countless numbers of people are giving the government free money. I know this because very few people achieve the maximum 401k contribution in 2018 of $18,500 per year.
Keep in mind to receive 10-year Public Service Loan Forgiveness, you must make payments on a qualifying income-driven repayment plan while employed full time at a not for profit. The plans most people choose are either the PAYE or REPAYE options. Both require 10% of your discretionary income (roughly equivalent to your Adjusted Gross Income, or AGI, minus a deduction).
The takeaway is by reducing your AGI, you reduce your student loan payments and receive more forgiveness, which is a creative way to pay off student loans. This is particularly true in the case of PSLF.
Contributing to Retirement with Student Loans is a Like Another Tax Break
Pretend Jim has a $100,000 per year and a family size of 3. His discretionary income would be equal to $100,000 minus 150% of the poverty line for a family of 3. That works out to $100,000 – $31,170 = $68,830.
His payment on the PAYE plan would be 10% of $68,830, or $6,683 per year. That’s about $574 a month in student loan payments. Assuming Jim is not married, then he would be in the 24% marginal tax rate for federal taxes. We’ll assume Jim lives in Missouri and pays 6% on his state income tax.
Since state income taxes are generally not that deductible on federal returns anymore with the new Tax Cuts and Jobs Act, we can say that the marginal tax rate, in this case is about 30%.
However, what if Jim is working towards PSLF? Could he save more in taxes on his contributions?
If he contributed the maximum $18,500 per year to his 401k pretax, then his discretionary income would fall to $50,330. His new monthly payment would be about $419 per month. He would save approximately $1,850 in student loan payments on a debt that will be forgiven.
How the Student Loan Retirement Savings Tax Break Works
The $1,850 in savings is worth more than that because that money would’ve been paid with after-tax earnings. That means $1,850 needs to be adjusted upwards for taxes to see how much it’s worth in pretax salary. Take $1,850/(1-0.3) = $2,643.
Recall that the marginal tax savings for retirement already was 30%. That means the tax savings for Jim would be ($18,500*0.3 + $2,643) / $18,500 = 44.3%
Should You Save for Retirement If You Owe a Bunch of Student Loans?
Recall that the income-driven plans apply even when you’re not going for PSLF. You can get loan forgiveness in the private sector too.
Check out what happens if a lawyer (call her Isabella) makes $60,000 per year with $200,000 of student debt. The two scenarios are if she saves nothing for retirement (top row) or saves the max for retirement (bottom row).
You’ll notice the tax bomb payment in 2038 (PAYE is 20 years) is larger if you save a lot for retirement. However, the payments over 20 years are almost half that of the zero-retirement savings row on top.
The answer to your financial problems long term if you owe a bunch of student debt is almost always this: fix your lack of an emergency fund and consumer debt and get serious about your retirement savings.
The Waterfall of Tax Efficient Investing with Student Loans
You have scarce resources that you are trying to make the most of if you have a bunch of student loans. I showed you the case of PSLF, but what about if you owe $200,000 of law school debt and you earn $60,000 per year?
In the case where you owe more than double your income in student debt and you don’t qualify for PSLF, you might want to go for the 20-25-year version of loan forgiveness where you owe taxes at the end.
Here’s a general order of taxable account investing that I like to follow for my clients. Notice that I place debt over a 5% as a higher priority than investing in a brokerage account, but retirement savings comes before saving for the tax bomb for your student debt.
Why Student Debt is Different from Other Kinds of Debt
Show me a credit card, personal loan, or auto loan that can be paid based on your income. They don’t exist that I’m aware of.
Student debt can be reduced and managed long-term through the intelligent use of the existing rules.
Debt above a 5% is a pain in the butt and prevents you from working the jobs and hours that you’d prefer. Meanwhile, student debt doesn’t get in the way of your goals because you can always pay down debt or invest according to your income.
Why Did I Choose this Order of Taxable Account Investing?
Keep in mind that a 401k match is free money. That’s a 100% return, and it’s better than even the highest interest credit card. Of course, credit cards do carry massive double-digit rates. That’s why I’d suggest prioritizing that second in your budget. Get $10,000 in the bank with no credit card debt.
After that, max your 401k and Health Savings Account. That will cut your payment on your student loans if you haven’t already refinanced.
If you have no retirement savings but your tax bomb is covered at the end of your PAYE or REPAYE period, then you’re out of luck. That’s why retirement comes first before your tax bomb savings. Retirement savings are protected more from creditors than any other account. I seriously doubt the IRS will be able to touch retirement savings when the tax bomb comes due (if you’re not doing PSLF).
If you have student debt that needs to be refinanced, I would focus paying off student loans faster over-investing in your brokerage account. Stocks are at all-time highs, we haven’t had a recession in 9 years, and people in California will trade their first-born child for a lousy condo.
If we have a huge crash in the next five years, you’ll be glad you have less debt or in the process of paying off student loans in full. I’m not saying that investing couldn’t earn more returns long term. It’s just that you want to focus on getting rid of troublesome non-tax-deductible debt quickly.
If you have a mortgage or other low-interest debt, feel free to put that off so you can invest instead.
Go to Your Retirement Login and Increase Your Contributions
Should you save, invest, or pay off student loans? If you have student debt, one of the biggest mistakes you can make is not prioritizing your retirement savings right now. In most cases, you’ll get additional tax savings by contributing to your pre-tax 401k.
Borrowers with student debt should generally avoid the Roth accounts for 401k’s. If you want to save in a Roth IRA after maxing your 401k, by all means, do it.
The scary thing I see happen all the time is a student loan borrower has no emergency fund and maybe some credit card debt but for some reason feels good about maxing their Roth IRA at $5,500 per year.
Focus on saving $18,500 in your 401k, getting rid of high-cost consumer debt, and getting a plan for your tax-efficient investing with student loans. Your future self will thank you.
Have you started shaping a plan for retirement? If so do you contribute to any retirement accounts?