2208: Roth or Traditional When You Have Student Debt by Travis Hornsby of Student Loan Planner on Retirement Accounts

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[00:00:43] Episode 2208 Roth or traditional when you have student debt by Travis Hornsby of studentloanplanner.com Hello everybody. I'm Greg Audino and instead of sharing our usual relationship content, here in our weekly bonus episodes we share previously aired audio from the other shows

[00:01:02] in our network. And this time around I've got a post for you from our finance show, Optimal Finance Daily, all about student debt and how to manage it with different investment accounts. So let's hear Diana's narration and commentary as we optimize your life.

[00:01:16] Roth or traditional when you have student debt by Travis Hornsby of studentloanplanner.com A reader hit me up recently and wanted to know if I thought he should choose a Roth or traditional account for his retirement savings. This is a hard decision even if you have no

[00:01:38] student debt. However, it's made out to be an easy one with tips from friends, relatives and even late night PBS broadcasts. For those who don't know, you can save for retirement with

[00:01:50] two different types of accounts. A Roth account allows you to pay taxes now and when you retire your withdrawals are tax-free. A traditional account gives you a tax deduction now but you

[00:02:01] must pay income taxes on withdrawals down the line. We'll weigh the pros and cons of each option when you have student debt. Usually the best choice defies conventional wisdom. Here's what the reader asked about Roth versus traditional. Quote, I'm intrigued by one particular aspect

[00:02:21] of your post regarding the top 40 things to know about public service loan forgiveness. Specifically reducing adjusted gross income and getting indirect matching on pre-tax retirement contributions. I like this idea and I'm thinking about sending more money into a

[00:02:39] pre-tax realm but can you comment on how this plays out if someone with low income now and higher expected income later, like your wife or myself who are doctors, specifically residents, has the opportunity for post-tax retirement investment such as a Roth 401k. I'm already maxing out my

[00:02:58] Roth IRA so I'm specifically asking about the Roth 401k although I think for the purposes of this they're interchangeable. Say I make $60,000 a year as a resident. This puts me in the 25% tax bracket. $100 post-tax equals $133 pre-tax. Roughly with the understanding that the tax bracket is

[00:03:21] not flat but tiered maybe you know a better way of comparing these. I tried using various online calculators to do the math to show the difference between putting $133 in a pre-tax account or even $136 as the extra $33 reduces my adjusted gross income and decreases my loan repayment by 10%.

[00:03:43] That's $3.30 and $133 plus $3.30 is $136 versus $100 in a post-tax but can't find a good one to calculate the taxes at withdrawal. Sorry if this makes no sense but can you see where I'm going? Should I invest pre-tax now and reduce my adjusted gross income to reduce my loan repayment

[00:04:07] or should I invest post-tax, pay a bit more on my loan but save by limiting my taxes at withdrawal when I expect to be in a higher tax bracket? My first rapid-fire thoughts. The real

[00:04:24] question here is what happens if you're rich and have to pay a lot more in taxes than what you paid as a resident. Another point, the reader makes a mistake with the math in terms of how it

[00:04:34] affects the loan repayment. If the reader took $100 and put it into a pre-tax retirement account then he would have to pay $10 less on his loans the following year. What you contribute to traditional retirement accounts lowers your income for the current calendar year. That means

[00:04:54] if you saved the maximum $19,500 in your traditional 401k your student loan payment would be reduced by $1,950. When would that happen? The next time you certify your income and produce a tax return with lower adjusted gross income. It's confusing but loan servicers

[00:05:15] tend to use your taxable income from the prior year to determine your income driven repayments for the coming year. With public service loan forgiveness, the retirement answer is obvious. If you're looking for public service loan forgiveness, the Roth account almost never makes sense. 99%

[00:05:35] of borrowers using public service loan forgiveness should be exclusively using a traditional account because you want the tax deduction now. Our resident doctor was only in the 25% federal tax bracket. However, most resident programs are located in higher tax areas with a high

[00:05:56] cost of living. That means our reader is probably not deciding where to put his next $15,000 but more like his next $5,000. Let's assume his state charges 5% income tax. Now we're up to 30% that he's saving in taxes for each dollar of contribution to a traditional

[00:06:17] retirement account. However, as I mentioned, each dollar saved also reduces his loan payment by 10 cents. So that's like a 10% tax savings in the form of lower student loan payments. This 10 cents is a taxable amount so it needs to be grossed up for taxes. Hence, it's probably more

[00:06:38] like 13 cents for each dollar saved that you get back in the form of lower student loan payments. In that case, the marginal savings of our resident contributing to a traditional account

[00:06:50] is about 43%. But I'm gonna be rich. Why won't you let me use the Roth? The vast majority of doctors are not in a 40% bracket in retirement when they're pulling out required minimum distributions at 70. Like probably over 90%. Even so, most physicians have to go to the

[00:07:12] complicated step of doing a backdoor Roth IRA because they're over the income limits. Heck, many never retire period. You're protecting against downside risk in retirement when you save in a traditional account. If you're going for public service loan forgiveness, you should

[00:07:30] really focus on building assets and protecting against the worst case scenario, which is you having to work forever. Maybe you could say taxes are going up and that's why you want to use a Roth. If so, then the reward for charitable contributions would go up too. You can

[00:07:47] currently contribute much of your required IRA distributions to charity and deduct it unless you're Mitt Romney. And if you're that rich, then you have bigger problems to worry about. If you did

[00:07:58] end up poorer than you thought you'd be, you'd better hope you took the deduction early and saved more with the traditional. The way I look at it is downside protection. Most people save almost nothing relative to their incomes, professionals included. And those folks need to drastically

[00:08:15] increase pre-tax before they even think of a Roth 401k. You just listen to the post titled Roth or traditional when you have student debt by Travis Hornsby of studentloanplanner.com. I thought this was a great analysis from Travis on considering Roth versus traditional when you

[00:08:38] have student loan debt. But even when you don't have student loan debt, we all have to consider where we want to put our retirement savings and the pros and cons of pre-tax versus post-tax. I

[00:08:49] think it all boils down to your overall financial goals and assumptions you're willing to make about the future. Choosing between traditional or Roth often comes down to how much you're making now and how much you expect to be making when you're drawing down from these accounts. Reason being

[00:09:06] that you're deciding on when you're going to pay tax on this money now or later. And since you want to optimize for taxes, you want to pay that tax when you're in the lowest tax bracket. If your

[00:09:17] overall financial goal is to retire early, your best bet is probably a traditional IRA, assuming you aren't over the income limits to contribute and enjoy that tax deduction. The mad scientist does a great analysis as to why in his article titled traditional IRA versus Roth IRA, the best

[00:09:37] choice for early retirement. And his rationale is based on the fact that you can set up a Roth conversion ladder in early retirement when your income is low and pay the tax then. But let's say

[00:09:48] you're young, you don't have your heart set on early retirement and you're already in a really low tax bracket. I can see how a Roth would be attractive in this scenario, especially because you have flexibility to withdraw money prior to retirement without penalties. It's a tricky

[00:10:03] question and the right answer is highly dependent on your unique circumstances. But here's the thing, don't let analysis paralysis stop you from contributing to either one. I decided to go

[00:10:15] for the Roth IRA because at the time my income was too high to realize the tax benefits of a traditional, but it was lower than the thresholds to contribute to a Roth. Also I was already saving

[00:10:28] a bunch of pre-tax money by fully funding my 401k and I like the idea of having different buckets of money that can be accessed at different times for different reasons. Also being able to access

[00:10:39] my contributions before retirement penalty free gives me additional peace of mind. That should do it for another edition of Optimal Finance Daily. I'll be back tomorrow as usual so I'll see you there on the Wednesday show where optimal life awaits.