Planning for retirement always seems to take a backseat when it comes to dealing with student loans. In many ways the debts of the past make planning for the future difficult.
The many variables of IBR and PAYE make planning even more difficult. At present, loans can be forgiven after 20 to 25 years of payments, but there could be a huge tax bill at the end. In the future, Congress may decide not to tax this forgiveness as many have advocated. There is also the fear the forgiveness might be eliminated leaving borrowers in the cold.
Because of the uncertainty, many borrowers have a savings account and money set aside just for student loans. The problem with setting aside money in this manner is that it leaves little to nothing for retirement.
The Best of Both Worlds
If you get crafty, it is possible to save for retirement and reduce your monthly payments on your student loans.
As many borrowers know, your IBR or PAYE payments are based upon your discretionary income. If your discretionary income goes down, your monthly payments go down. Saving for retirement in a 401k is not just a tax deduction, but it also lowers your discretionary income. That means any money you can save for retirement, lower your tax bill, and lower your student loan payments all at the same time.
How it works
Discretionary income is calculated using your tax return, specifically the adjusted gross income or AGI. As your AGI goes up or down, your IBR or PAYE payments will also go up or down. If you set aside retirement money in a 401k, it is a tax deduction that reduces your AGI. Bottom line: more towards retirement, less towards student loans.
The scary part with saving for retirement instead of addressing your student loans is that a student loan balance can actually grow while you are on IBR or PAYE. Money applied towards retirement cannot be touched until you reach retirement age, or there is an early withdrawal penalty. If things get ugly on the student loan front, you may need that 401k money.
Looking at the math, this risk is a little less scary. Suppose you put $1,000 into your 401k each month. Depending upon your repayment plan, that $1000 towards retirement likely means you save $100 or $150 on your student loan payment each month. If you have to withdraw the money early from your 401k, there is a 10% penalty, meaning instead of getting $1,000 out, you only get $900. While that is disappointing, you were already up by $100 or $150, so the penalty merely negates the money you saved on your student loan payment.
In short, putting the money in your 401k could put you way ahead financially. However, even if things get ugly and you have to dip into it to bail yourself out on the student loan front, you still end up more or less breaking even. Thus, borrowers on income driven repayment plans would be wise to consider retirement savings as a way to reduce loan payments and responsibly plan for the future.