Fund Roth IRA or pay student loans?

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zrohm
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Fund Roth IRA or pay student loans?

Post by zrohm »

Hello, Boglehead community! First-time poster here. I'm excited to interact with some of the brightest and most financially-savvy investors online!

I am a 25 year old who just graduated from medical school. The entirety of my loans are from medical school; I have no other debts. This July I will start working as a resident physician in a major metropolitan area earning about $54,000/year.

My total student loan burden is $200,000, all of which are federal. The interest rates vary (see below). During my residency, I will be making monthly payments of about $600/month using an income-based-repayment (IBR) model.

Principal Interest Rate (%)
$2,000 6.8
$8,500 6.8
$5,500 4.5
$34,222 6.8
$44,944 6.8
$40,000 5.41
$42,922 6.2

I would like some help deciding whether it is a good idea for me to pay on my student loans over and above my IBR. Or should I open up a Roth IRA and park money into there instead? I also have access to a Roth 403(b) but without employer matching. I have about $1000 / month that I can either assign to a retirement fund or pay down debt.

The average physician in my chosen field makes about $220,000/year. Once I complete residency, I expect to make around $200,000 and aggressively pay back loans to the tune of $100,000+/year.

What do y'all think? Thank you for your help!
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grabiner
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Re: Fund Roth IRA or pay student loans?

Post by grabiner »

Welcome to the forum!

Paying down student loans at 6.8% is a risk-free 6.8% return, which is much better than you can get on your investments, and it will last several years because of the time it will take to pay off the loans. You do lose the right to get tax-deferred growth in your Roth IRA/Roth 403(b) for the rest of your career, as you will probably hit the contribution limit. However, if you invest in something tax-efficient such as Total Stock Market Index when you must make taxable investments, you don't lose that much to taxes anyway.

To get the benefit of the Roth IRA for tax-deferred savings, you might put your emergency fund there; this works because you can withdraw contributions from a Roth IRA without penalty, and gives you the benefit of having the money in the Roth IRA later. If you do this, invest the Roth IRA in a low-risk bond fund so that it won't lose money. See Roth IRA as an emergency fund on the wiki.

But once you have maxed out the Roth IRA, additional dollars should go against the loans. Of the loans at the same rate, go after the smallest ones first, as this will decrease your minimum payment due and thus reduce the amount you need to keep in an emergency fund.
The average physician in my chosen field makes about $220,000/year. Once I complete residency, I expect to make around $200,000 and aggressively pay back loans to the tune of $100,000+/year.
It probably won't work out quite this fast. When you earn $200,000, you will be in a high tax bracket, and thus you may pay 1/3 of your salary to the IRS and state. You will also want to spend more money.
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market timer
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Re: Fund Roth IRA or pay student loans?

Post by market timer »

How soon could you refinance these loans with a private lender? Do you need to start your $200K job first, or is a residency sufficient?

Do you qualify for an interest-free period on any of your subsidized loans due to partial financial hardship during residency?
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ruralavalon
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Re: Fund Roth IRA or pay student loans?

Post by ruralavalon »

Welcome to the forum :) .

For that extra $1k/month, first fully fund a Roth IRA and then the remainder toward paying off your student loans in the order that you listed them.
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sharpjm
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Re: Fund Roth IRA or pay student loans?

Post by sharpjm »

I would probably suggest using the Dave Ramsey snowball approach (or whatever he calls it).

Start with $2k, 6.8%. All extra payment go to it until it is paid off. Then with the extra cashflow from that loan payment, apply its payment to the $8.5k 6.8 loan as well as all extra payments. Keep going up the ladder focusing only on the 6.8% loans. Then focus on the loan with the highest rate that remains. I would pay off all of the loans before investing since even 4.5% is a pretty good guaranteed return.
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zrohm
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Re: Fund Roth IRA or pay student loans?

Post by zrohm »

Thanks for the great advice! At this moment, I am leaning toward paying down my student loans instead of funding a Roth IRA.
market timer wrote:How soon could you refinance these loans with a private lender? Do you need to start your $200K job first, or is a residency sufficient?

Do you qualify for an interest-free period on any of your subsidized loans due to partial financial hardship during residency?


To answer your questions, it's somewhat tricky refinancing during residency because my income-to-debt ratio is terrible for the time being. Traditionally residents refinance their loans when they are coming out of their training programs. There are now a few lenders who will do refinancing underwriting for resident physicians based on the average physician salary out of residency. I'm looking into the possibility of refinancing with these lenders.

I'm not sure whether I qualify for interest-free periods on subsidized loans. I will also look into this. Unfortunately, the vast majority of my loans are unsubsidized. To my knowledge, the US department of education is no longer offering subsidized loans to graduate students.
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market timer
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Re: Fund Roth IRA or pay student loans?

Post by market timer »

With federal student loans, one important but overlooked feature is that interest accrues without compounding. In other words, during the negative amortization phase of your loan (where your payment does not cover interest), you are effectively accruing a 0% interest loan (the accrued interest is like a 0% loan). If you were to pay down your loans more aggressively, you would be paying off this 0% interest loan first. Therefore, at the margin, it is likely much better to contribute to retirement accounts during residency before making student loan payments above the minimum.
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tludwig23
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Re: Fund Roth IRA or pay student loans?

Post by tludwig23 »

market timer wrote:With federal student loans, one important but overlooked feature is that interest accrues without compounding. In other words, during the negative amortization phase of your loan (where your payment does not cover interest), you are effectively accruing a 0% interest loan (the accrued interest is like a 0% loan). If you were to pay down your loans more aggressively, you would be paying off this 0% interest loan first. Therefore, at the margin, it is likely much better to contribute to retirement accounts during residency before making student loan payments above the minimum.
Good point. Given the initial numbers, the OP would be accruing about $400/month in additional interest if making only the minimum payment. An extra $1,000/month would be reducing the principal by about $600/month, so as you point out, he'd be saving the 6.8% interest only on the $600.
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53timr
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Re: Fund Roth IRA or pay student loans?

Post by 53timr »

I have a different opinion on this...stash away as much Roth money as you can in a total market index fund before your income hits the limits. With the number of years you have for this money to grow tax free you will have a very tidy sum of tax free money. You can pay off those student loans after your income hits the Roth income limit.
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grabiner
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Re: Fund Roth IRA or pay student loans?

Post by grabiner »

market timer wrote:With federal student loans, one important but overlooked feature is that interest accrues without compounding. In other words, during the negative amortization phase of your loan (where your payment does not cover interest), you are effectively accruing a 0% interest loan (the accrued interest is like a 0% loan). If you were to pay down your loans more aggressively, you would be paying off this 0% interest loan first. Therefore, at the margin, it is likely much better to contribute to retirement accounts during residency before making student loan payments above the minimum.
However, the accrued amount is a relatively small part of the loan balance unless the loan has been in negative amortization for a very long time. Once you cover the accrued interest on the smallest loan, you earn 6.8% on the remaining accrued amount, so the benefit from paying it off in full (which you can do quickly) is close to the full 6.8%.
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StormShadow
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Re: Fund Roth IRA or pay student loans?

Post by StormShadow »

Attending here, 1 year out of training.

My thoughts:
Was also in IBR with same salary, and initially my monthly payments were only $340/mo (all interest). Midway through training, got married to DW who made more money and auto monthly payments bumped up to $1,300 (some to interest and some to principal). Tougher on the wallet, but paying down principal felt much better.
Maxed out my roth during residency/fellowship and still glad I did.
Lived extremely tight as a resident.
First year as attending, tried to live like a resident but once DW got pregnant... :mrgreen: Life happens. Best to have a plan, but stay flexible enough to adjust.
Paying $100k per year would be a stretch at $220k salary. Even $50k/yr is tough (which is about what I do), but much easier to achieve.
When approaching the end of residency, make sure to get your FCVS, DEA and state license squared away.
Cheers! :beer
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market timer
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Re: Fund Roth IRA or pay student loans?

Post by market timer »

grabiner wrote:However, the accrued amount is a relatively small part of the loan balance unless the loan has been in negative amortization for a very long time. Once you cover the accrued interest on the smallest loan, you earn 6.8% on the remaining accrued amount, so the benefit from paying it off in full (which you can do quickly) is close to the full 6.8%.
Agreed, if not much interest has already accrued, and the servicer allows OP to pay specific loans, the interest savings will be closer to 6.8%/year. In my case, having consolidated loans, this isn't possible. But I expect OP can choose to pay specific loans.
Two Headed Mule
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Re: Fund Roth IRA or pay student loans?

Post by Two Headed Mule »

The important point in this type of situation is that the decision of whether to invest in tax-advantaged space (that will otherwise be lost) or pay down your student loans must be revisited annually. It may be the case that you should pay down loans with excess funds this year. However, at some point, as the anticipated payoff date of the loans draws closer, there will come a time where you should switch to maxing out tax-advantaged space prior to paying off the remaining loan balance. That is because as the loan payoff date approaches, the value of lost tax-advantaged space outweighs the short term interest cost of the loan.

Assume you can earn 2% risk free in a roth. Your loans cost you around 6.8%, for a 4.8% annual spread. Suppose you determine that, if you focused each year on maxing out tax-advantaged space before paying off the loan, you would have the loans paid off in 7 years. In that case, investing in the roth this year means you will be down (on this year's roth investment) approximately 34% at the end of 7 years (7 x 4.8) (actually 28% -- (1.02/1.068)^7 -- but the exact math isn't important). This is actually a close call because the cost of the permanent loss of roth space -- particularly for a high earner -- is in that ball park. That is what you are giving up by focusing on paying off the high-cost loan first. Even if you don't value tax-advantaged space that highly, at some point, the answer to how long it will take to pay off the loan while focusing first on tax advantaged space will be 5 years or under. When that occurs, you should almost certainly switch to focusing on maxing out your tax-advantaged accounts first.

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Last edited by Two Headed Mule on Sat May 23, 2015 3:34 pm, edited 2 times in total.
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Sandi_k
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Re: Fund Roth IRA or pay student loans?

Post by Sandi_k »

I would max out the Roth now (~$450 per month), and send any remainder (~$550 per month) to your loan.

You will be unable to contribute to a Roth because of income limits soon, and I think having a head start on retirement saving is a good thing.
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