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.

  • Josh Lewis

    This is idiotic. You have to recertify every year with your income tax return. At that point, the 401k disbursement becomes discretionary income for the following year. Not only would you be paying a 10% penalty, but the money will then be used to calculate and increase your income based payment.

    • I think you miss the point. Taking a 401k disbursement would be a really expensive move. But SAVING money in your 401k increases your retirement and lowers your discretionary income meaning lower student loan payments. The point is that putting money in a 401k has major advantages

      The bit about having to take a disbursement on your 401k is a potential risk to saving the money. Just make sure you have an emergency fund in place.

    • Josh Lewis

      The point I was addressing was the statement that a borrower will save 10% of the monies invested so the 10% penalty on a disbursement will be a wash. That’s entirely false. “Hiding” income in a 401k that you can’t afford to save otherwise is not a smart move. Beyond the fact you would be paying 20% on a distribution (penalty & future payment calculation) instead of just 10% from the start, you are avoiding paying more towards loan principal if you are even paying on principle at all. Compounding that will come with a hefty tax penalty 20 years down the road. The Department of Ed. is going to get their 6.5% every year (or at least the 25% tax on what’s forgiven). There is no guarantee your 401 k will. Unless you are getting matching funds, are fully vested, and do not foresee the need for a premature disbursement; this is a poor tool for lowering payments.

    • That is a fair point Josh. I was operating under the assumption that if you were pulling funds from your 401k it meant that you no longer had an income and therefore would be in a different tax bracket, but there are many circumstances which might constitute an emergency, so that may not be a fair assumption. In light of your commentary I will update the article to have some stronger language on the risk of an early withdrawal.

  • Justin Abbott

    Currently enrolled in PSLF and was curious about this very topic. I have started placing my discretionary income in a deferred comp program and was wondering how that would affect my future student loan payment when I recertify my income. Do you think that deferred comp (457 account) would affectively lower AGI in the same way that you suggest it would for 401K or 403B investments?

    • Yes. The 457 is an above the line deduction just like a 401k. When I worked for the government, I had a 457 plan and it did lower my AGI. Taking advantage of the 457 is a great way to get the most out of PSLF and build your retirement.