Retirement, taxes, and student loans are a horribly unpleasant trio for most millennials. For many, taxes are too high, student loans will never be paid off, and retirement is a far away dream at best. In short, it is bad news, bad news, and more bad news. The good news is that if you are willing to subject yourself to all three topics at once, there is opportunity for major improvements on all three fronts.
The key is understanding how these three financial issues come together.
The vast majority of student loan debt is owned by the federal government. As many borrowers know, the best federal government repayment plans are based upon your income.
In order to determine your income, the Department of Education looks at your most recent tax form. Specifically, they look at your AGI (Adjusted Gross Income). The higher your AGI, the more you pay.
One of the best ways to lower your AGI is to make contributions to an eligible retirement account. In many cases up to $18,000 can be put towards retirement.
Help on three fronts
Assume for a moment that you set aside $12,000 per year for retirement on the company 401k plan. While this would certainly mean lower paychecks, the gains are huge.
Taxes – If you are in the 25% tax bracket, the $12,000 put in your retirement account means that your tax bill is $3,000 lower. And that is the federal tax bill alone. Depending on your state income tax, the savings could even be larger.
Student Loans – The $12,000 put towards your retirement lowers your AGI by $12,000. When the Department of Education calculates your student loan payment, you will show a monthly income of $1,000 less. For people on IBR, that translates into monthly payments that are $150 less. If you are on Pay As You Earn or REPAYE, you are saving $100 per month. On a yearly basis you are saving between $1,200 and $1,800.
Retirement – The $12,000 in your retirement account can now start earning interest. This way compounding interest works for you rather than against you. The more you save and the sooner you save, the better your retirement will be. Plus, if your employer does any sort of matching contribution, the money you save gets even larger, even faster. Otherwise, you are banking on social security in order to retire.
With money being tight, putting aside anything for retirement can seem far-fetched, especially if you are currently battling student loans.
The good news is that it doesn’t have to be that way. A $12,000 contribution to your retirement this year may seem enormous or even impossible, but a closer look shows that it isn’t the stretch you might otherwise think. For starters, well over $4,000 of that $12,000 is not yours to begin with.
If I told you that giving up $2 today would mean that you get $3 in the future, how much would you give up? How much would you invest?
The Biggest Benefit
If you are on an income driven plan and working towards forgiveness, such as Public Service Student Loan forgiveness, this is a huge opportunity. The more you put towards retirement, the lower your monthly student loan payments will be, the less you will owe in taxes, and the more debt you will have forgiven. And we haven’t even discussed the advantages of early saving for retirement.
It is all about the small sacrifice now for a bigger benefit in the future.
A couple exceptions to remember
While we are strongly in favor of this approach, there are a couple factors to keep in mind when you put together your plan.
For starters, unless you actually plan on having your loans forgiven, student debt will eventually have to get paid off. The lower payments and extra retirement savings is nice, but the debt will last longer if you pay less on it each month.
Secondly, the 401k isn’t the perfect tax shelter. You might not pay any taxes when the money goes in, but the IRS certainly will be taxing you when the money comes out. If the tax rates are 50% in the future, you won’t come out ahead. If they stay the same or drop, you come out much better off.
How much should I put towards retirement?
The maximum is the ideal amount to put towards retirement. For some, it means whatever the IRS will allow. For most others, such a contribution just isn’t possible. In that case, you want to save the maximum you can afford. Because this takes some serious planning, finding that number can be a tricky proposition.
The best approach to finding your personal maximum might be to make a budget. List everything. Expenses as big as your rent and as little as the occasional cup of coffee should be included. Find your magic number. Once you decide how much money is necessary to live on, try to find a way to shield the rest form the IRS and the Department of Education. For many, this means a 401k contribution.
This plan may require some math, budgeting, and even some belt tightening, but the potential gains are huge.