Saving for retirement might seem unrelated to student loan payments and debt forgiveness.
Fortunately for many borrowers, it is possible to set money aside for retirement and eliminate student debt. In fact, saving for retirement can make it easier to repay federal student loans.
The Connection Between Retirement Contributions, Monthly Payments, and Student Loan Forgiveness
Federal student loan borrowers have the option of enrolling in an Income-Driven Repayment (IDR) Plan.
The IDR plans are popular because borrowers make payments based upon what they can afford, rather than what they owe.
When determining what a borrower can pay, the Department of Education calculates a borrower’s discretionary income. This calculation starts with the borrower’s Adjusted Gross Income (AGI) from their most recent tax return.
This is where saving for retirement enters the equation. Certain retirement plan contributions are tax-deductible. These tax-deductible plans reduce a taxpayer’s AGI. The lower AGI means lower student loan payments for borrowers on IDR plans.
Finally, a lower student loan payment means more debt can be forgiven if the borrower reaches the point of loan forgiveness.
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 means my monthly payment would be lowered 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.
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.
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.
Long Term Benefits:This approach has significant long term benefits. The $200 set aside for each paycheck can reasonably be expected to grow as time passes. By the time you reach retirement age, your original contributions may have grown considerably, 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 are in a position to forgo a bit of income today, the future benefits can be quite significant.
What Retirement Contributions will Lower Student Loan Payments?
Several different retirement accounts will achieve the goal of lowering IDR student loan payments.
Generally speaking, savers should look for accounts that are considered pretax or tax-deferred. In other words, pick a retirement account where taxes are paid when the money comes out; instead of when the money goes in.
Common tax-deferred accounts include the following: traditional IRA, 403(b), 457, and most 401(k) plans.
However, not all retirement contributions will lower IDR student loan payments. The retirement plans that don’t lower IDR payments use after-tax contributions. The most common examples are a Roth IRA and a Roth 401(k). These accounts are dubbed “after-tax” because savers pay taxes on the income first, and then put the money in their account. The advantage of Roth style accounts is that the funds can be withdrawn during retirement tax-free. Unfortunately, Roth contributions do not impact AGI calculations and will not lower student loan payments.
In addition to retirement account contributions, there are other ways to lower your AGI…
Other ways to Lower AGI
Unfortunately, not all tax deductions lower Adjusted Gross Income (AGI).
Tax specialists call deductions that reduce AGI “above-the-line” deductions.
In addition to retirement contributions, other common above-the-line deductions include:
- HSA or MSA Contributions (Health Savings Accounts or Medical Savings Accounts)
- Self-Employed Business Expenses and a portion of Self-Employed Taxes
- Student Loan Interest
More details on Above-the-Line deductions are available here.
If you pay someone to prepare your taxes, it might be a good idea to discuss options to maximize above-the-line deductions.