Without question, my favorite student loan hack is putting money in a retirement account so that you can get lower student loan payments.
For borrowers on income-driven repayment plans, monthly payments are calculated based on what a borrower can afford to pay. Putting money in certain retirement accounts essentially shields that income from being included in monthly payment calculations.
It might sound like a bit of accounting voodoo, but getting lower payments via retirement contributions is pretty simple.
Why Putting Money in a 401(k) or 457 Retirement Plan Means Lower Student Loan Payments
The whole “process” is basically three steps:
- Put money in an eligible retirement account.
- Claim a tax deduction for the retirement contribution.
- Get a lower student loan payment on an IDR plan.
Step three is the one with the potential for confusion. To make sense of it, borrowers need to understand how monthly payments on Income-Driven Repayment (IDR) plans work.
The appeal of an IDR plan is that borrowers can make payments based upon what they can afford to pay. The Department of Education calculates a borrower’s “discretionary income” in order to determine what they can afford to pay.
The starting point for the dictionary income calculation is usually the borrower’s Adjusted Gross Income (AGI) from their most recent tax return. The larger your AGI, the more you will be expected to pay on an IDR plan.
Shifting back to the retirement side of the equation, some retirement contributions qualify for a tax deduction. This tax deduction lowers the taxpayer’s AGI. The reduced AGI essentially shelters income from student loan payment calculations.
In other words, putting money in a retirement account lowers your income for tax purposes. This “lowered income” means lower payments on income-driven repayment plans.
If things are still a bit fuzzy, the next section will cover the eligible retirement accounts, and later on we will do a quick example with actual numbers.
The Exception: Roth 401(k)s and “Post-Tax” Accounts
Sadly, not all retirement account contributions mean lower student loan payments.
Some retirement accounts are considered “pre-tax” because the money placed in the retirement account isn’t taxed yet. These pre-tax contributions are the ones that lower student loan payments. Common examples include most 401(k)s, 457 plans, and IRAs.
Borrowers don’t get a student loan benefit if the retirement account is a “post-tax” account. Post-tax contributions don’t lower your tax bill, which means they don’t help with student loan payments. Common examples of post-tax retirement accounts are Roth IRAs and Roth 401(k)s.
Sherpa Tip: If you get a tax deduction for putting money in your retirement account, it also means lower payments on income-driven repayment plans.
Other Ways to Save for Retirement and Lower Student Loan Payments
Clever borrowers might also wonder if other tax breaks mean lower student loan payments.
The answer is yes. Several other tax deductions also mean lower student loan payments.
However, not all tax deductions mean lower student loan payments. The critical detail on tax deductions is whether or not the deduction lowers your AGI. Tax pros call deductions that lower AGI “above-the-line” deductions. The tax breaks that don’t lower AGI are “below-the-line” deductions.
The following deductions are “above-the-line” and will lower income-driven student loan payments:
- Health Savings Account Contributions
- Alimony Payments
- One-Half of Self-Employment Taxes
- Student Loan Interest
Deductions that do not lower student loan payments include the following:
- Charitable Contributions
- Mortgage Interest
- State and Local Taxes
Taking Advantage of Lower Payments for Tax Breaks
Before getting too excited about the opportunities for lower student loan payments, it is worth remembering that debt elimination is the goal of all borrowers. Lower monthly payments are nice, but they also mean spending more on interest in the long run.
The people chasing after student loan forgiveness will benefit the most from using retirement contributions to lower payments. If you are on your way to Public Service Loan Forgiveness, putting money in the correct retirement account means: lower monthly payments, a reduced tax bill, more money saved for retirement, and more student debt forgiven.
Even if forgiveness isn’t on the horizon, the lower payment is still helpful. If you have a reduced federal student loan bill, it means you can focus your efforts on attacking your high-interest private loans or saving for a home down payment.
An Example with Actual Numbers
Suppose I make $60,000 per year working for the government.
I have a lot of federal student loans, so I sign up for an income-driven repayment plan. If I choose the REPAYE plan, my monthly payments will be $341 per month, according to the Department of Education Federal Loan Simulator.
I realize that I need to be saving more for retirement, so I have my employer start withholding $200 per paycheck for my retirement. Taxes vary from state to state, but for this discussion, let’s assume my $200 contribution per paycheck lowers my take-home pay by $150. After a full year, I will have set aside $5,200 for my retirement.
That retirement contribution lowers my AGI by $5,200. According to the loan simulator, the lower AGI reduces my monthly payment to $297 per month. If I’m working for an employer eligible for PSLF, the lower payments would mean more debt forgiven after ten years.
In the months I receive two paychecks, I will have set aside $400 for retirement, spent $44 less on my student loans, and only lost out on approximately $300 worth of take-home pay.
To recap, by setting aside money for retirement, I’ve accomplished the following:
- Lowered my monthly student loan payment,
- Increased the money set aside for my future,
- Lowered my tax bill, and
- Increased the amount of debt that can be forgiven.
Long-Term Benefits: This approach has significant long-term benefits. The $200 set aside each paycheck can reasonably be expected to grow as time passes. Your original contributions may have grown considerably by the time you reach retirement age, depending upon your investment strategy. A hidden advantage to this approach is that borrowers get an early start on interest working for them instead of against them.
Clearly, some sacrifice is required to utilize the connection between retirement, payments, and forgiveness. However, for the borrowers who can forgo a bit of income today, the future benefits are pretty significant.
Why this is my Favorite Student Loan Hack?
For many student loan borrowers, retirement is a problem for the future. Student loans are the crisis of the present.
Taking advantage of this hack requires setting money aside for retirement. I love the idea of saving for the future and making the present a little bit easier.