Retirement Planning for IBR and PAYE borrowers

Michael Lux Blog, Lower Payments, Money Saving Tips, Student Loans 6 Comments

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 risk

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.

Before “shielding” your income via a 401(k) you should make sure that you have an adequate emergency fund in place.  You don’t want to be in a situation where you are setting aside money for the future that you need in the present.

It is also important to view this approach in the context of your other financial goals.  If you are going after student loan forgiveness, especially the public service version, this approach can be very advantageous.  However, if you are looking to pay off your loans as quickly as possible to minimize interest spending, the math becomes more complicated.

Bottom Line

Many people think that having student loans means saving for retirement is off the table.  While student loans certainly complicate saving for retirement, they don’t have to prevent it.  In some situations, you can set extra money aside for retirement and spend less on your student loans.