Student Loans - Question on Maxing Roth or Traditional 401k + Savings

[NOLA Rob]

I'm currently maxing a Roth 401k at work. My wife has significant student loans that we are on schedule to pay off in exactly 48 months at our current payment levels (not counting tax refunds, extra income, bonuses, etc...). We are in a 31%-36% tax bracket when counting state and federal taxes (depending on my wife's bonus, a switch to a traditional 401k may bump us back down to 31%). Per our calculations, if I switched to a traditional 401k and put the yearly savings of $5270 - $6,120 towards her student loans, her loans would be paid off in 38 months instead of 48.

My wife wants me to continue putting the money in the Roth, but I'm torn. I have two related questions: (1) Should I switch to a traditional 401k and put that money towards the student loans or should I keep contributing to the Roth 401k? (2) If I was contributing to a traditional 401k, my question would be whether it is better to put the $5270 - $6120 towards her student loans or into additional taxable investment accounts?

Our current thought is that the money we invest now is the most valuable in our lives due to compound interest, time to retirement, etc.... It seems like we would do better to either do the Roth or the traditional + investing the savings in taxable accounts, rather than contributing the extra amounts towards the student loans. While the debt is a burden, we tend to think that years down the road we will be much happier to have either a maxed out Roth 401k or a traditional 401k + tax savings invested in taxable accounts, as opposed to having taken that money away to speed up the student loan repayment by 10 months.

I know a lot of you guys are already down the road from me, what would you advise us to do?

 

[LOL!]

Are you gonna retire early? Will your taxable assets be significant in early retirement? Will you be able to convert your traditional 401(k) to a Roth IRA in early retirement and pay no taxes like many folks? Will you move to a no-income-tax state in retirement? Did you mentioned the rate on the loan(s)?

 

[harley]

If it were me in this situation I'd do the switchover to the pre-tax IRA instead of the Roth, even leaving the student loan part of the question out. At the tax bracket you are in the savings would be significant. You sound like you are young enough that there is no way to guess what the tax situation will be when you retire, but odds are good that you would be in a lower bracket. You may be able to convert to a Roth at a lower bracket (depending on what the future holds). Or at least switch to part Roth part traditional 401(k) if that's allowed.

As far as the loans, paying them off faster would be dependent on what the interest rate is. If it's low (in the 3-4% range) you could probably just continue to pay them off on schedule and invest any traditional IRA savings into after tax investments. If it's a higher rate, then I'd definitely do the traditional IRA switchover and pay the loans down faster. You can always switch back to a Roth once they are paid off. If you think that's the best way to go.

In our case we were usually in the (currently) 25-28% federal bracket, and have been doing Roth conversions in retirement in the 15% bracket. It does my heart good to slip a few extra dollars out of Uncle Sam's pocket into my own. And it's legal, too!

 

[PennStateCLJ]

I concur with Harley.

Can you list the amounts and interest rates for all of your loans? Perhaps minimum payments/what you are currently putting towards them too.
Car loan- x$ at x%
Mortgage- x$ at x%
Student loans- x$ at x% broken down by each individual loan
Credit cards-
HELOC-
Personal loans-


The answer will depend largely upon these rates. But as I mentioned in your first intro post, I think you should be doing traditional 401k contributions.

If you list the 401k options and expense ratios we can evaluate whether it is a decent 401k plan or a high priced plan, which might change advice also.

 

[Animorph]

Definitely should be using the traditional 401k, not the Roth. Use the Roth only if you can stay in the 15% tax bracket. Sounds like you're past that now. You may be able to convert when you have no income if you retire early. Even if you never convert, your average tax rate is much lower than your marginal tax rate, and it's all being taxed at your marginal tax rate now. Unless you expect your average tax rate in retirement to match or exceed your current marginal rate, use the regular 401k.

Normally I say pay back the student loan only if your portfolio gains will not exceed the loan interest, including any tax effects. Tough to predict, especially now. Over four years it probably isn't a big deal either way, and the investable value will be declining with time. So unless it's a 3% rate or so, I'd just keep paying it normally. if it's 6% or more I'd pay it off early.

 

[NOLA Rob]

Are you gonna retire early? Will your taxable assets be significant in early retirement? Will you be able to convert your traditional 401(k) to a Roth IRA in early retirement and pay no taxes like many folks? Will you move to a no-income-tax state in retirement? Did you mentioned the rate on the loan(s)?

My goal is to be financially independent at age 50. I'm really happy at my job and would not retire now if I was FI (might cut back a bit though). However, I would like to be FI by 50 because I have no idea whether I will still like my job after 22 more years in it. So, for purposes of this analysis, I'd like to act as though I will retire at 50 so that I can in fact retire at that point if I want to.

Regarding my taxable assets, I believe they will be what I view as significant (whether the people on this board would agree, I have no idea). We are currently putting $31,200 a year towards the student loans. In four years or less, at a minimum we will be able to put that $31,200 a year into taxable savings on top of two yearly roth ira's being maxed and one 401k being maxed. Hopefully this will increase as we go, but it is not clear what additional funds we will be able to invest as we have children or whether we will have less to invest once we have children and start saving for their college also.

The student loan rate is roughly 5.8% (graduate school loans only). With regard to moving, I don't think I will move to a state with no income tax because my wife and I really love New Orleans, but you never know. I'm planning as if we will stay here so that if we move it is an extra surplus.

On the conversion issue, I don't feel comfortable planning on it. My wife is very driven and does not really ever want to truly retire. Her vision of retirement is working for a non-profit and taking a decent amount of vacation time. She's pretty committed to that concept, so with my skepticism on relying on tax rates to stay around where they are today plus the idea of having at least one salary in addition to taxable earnings when I FIRE, I'm not comfortable banking on post-retirement conversions. I'm not sold on the roth as a must though. I don't know though, maybe that is poor planning.

@ Harley - thanks for the suggestions. That seems to be the mainstream view.

 

[harley]

On the conversion issue, I don't feel comfortable planning on it. My wife is very driven and does not really ever want to truly retire. Her vision of retirement is working for a non-profit and taking a decent amount of vacation time. She's pretty committed to that concept, so with my skepticism on relying on tax rates to stay around where they are today plus the idea of having at least one salary in addition to taxable earnings when I FIRE, I'm not comfortable banking on post-retirement conversions. I'm not sold on the roth as a must though. I don't know though, maybe that is poor planning.

I almost laughed out loud at this one, although no offense is intended. I suspect after 22 more years of working and possible motherhood she might not feel exactly the same way she does now. I certainly wouldn't be making my decisions based on this. My favorite saying was always "plan for the worst, hope for the best". If you save and invest based on the concept that you'd like to get out early or at least be FI, the worst that could happen would be that you'd end up richer than you planned. If you plan based on always expecting her income and she gets worn out by having to be a supermom/working wife you could end up coming up short. As far as the traditional vs. Roth, at the very least I'd hedge my bets and go 50/50. Divversification in all things. Good luck.

 

[ronocnikral]

just be aware that contributing to pre-tax IRA with both working people covered by an employer plan has a relatively low income maximum. $112k or something of the like.

I'm skeptical the conversion will ever go away. congresspeople like it as much as everyone else.

 

[NOLA Rob]

Can you list the amounts and interest rates for all of your loans? Perhaps minimum payments/what you are currently putting towards them too.
Car loan- x$ at x%
Mortgage- x$ at x%
Student loans- x$ at x% broken down by each individual loan
Credit cards-
HELOC-
Personal loans-

Car loan - None
Mortgage - $238,000 at 3.875% (Payment is $1,125)

Graduate School Student Loans Currently:
$20,027.25 @ 5.8%
$24,304.42 @ 7.5%
$41,678.42 @ 8.5%
$18,031.65 @ 6.8%

I'm not sure exactly what the total minimum payment is and how much extra on top we are putting in because my wife handles all of the student loan stuff.

Credit Cards - none
HELOC - none
Personal loans - none

On the student loans, we've just been piling all the extra money we had available after maxing out into the loans into the highest interest rate loan. The loans are all about 1 year into a 10 year payment plan. At the current payment plan it is 48 months until everything is paid off.

I almost laughed out loud at this one, although no offense is intended. I suspect after 22 more years of working and possible motherhood she might not feel exactly the same way she does now. I certainly wouldn't be making my decisions based on this. My favorite saying was always "plan for the worst, hope for the best". If you save and invest based on the concept that you'd like to get out early or at least be FI, the worst that could happen would be that you'd end up richer than you planned. If you plan based on always expecting her income and she gets worn out by having to be a supermom/working wife you could end up coming up short. As far as the traditional vs. Roth, at the very least I'd hedge my bets and go 50/50. Divversification in all things. Good luck.

Oh, I'm not banking on the income from her job at all in my planning. I'm just not banking on being able to convert at a low rate later in retirement because if she does keep working and tax rates increase, we may have more income than our retirement calculations would indicate. I think that is planning for the worst, hoping for the best right? Planning on having enough in a roth, tax-deferred, and taxable accounts to retire without her income? But, I'm coming around on the fact that I should be doing a traditional IRA based on the comments.

Even if you never convert, your average tax rate is much lower than your marginal tax rate, and it's all being taxed at your marginal tax rate now. Unless you expect your average tax rate in retirement to match or exceed your current marginal rate, use the regular 401k.

I'd never really thought about the marginal v. effective tax rate issues until you pointed that out. So if my marginal rate is 31-36% now, my effective tax rate would have to equal or exceed that later, which means I'd have to make a whole bunch more than I'm making in income later. Got it. I could calculate it, but do you know of a calculator as to exactly how much money at current tax rates you would have to make to equal a 31 or 36 (or whatever) effective tax rate?

 

[PennStateCLJ]

Car loan - None
Mortgage - $238,000 at 3.875% (Payment is $1,125)

Graduate School Student Loans Currently:
$20,027.25 @ 5.8%
$24,304.42 @ 7.5%
$41,678.42 @ 8.5%
$18,031.65 @ 6.8%

I'm not sure exactly what the total minimum payment is and how much extra on top we are putting in because my wife handles all of the student loan stuff.

Those loan rates are ugly. I assume she's making the minimum payments on the lowest APRs and targeting the 8.5% first with all extra funds?

Once those are gone, I think you should focus solely on taxable investing vs. mortgage paydown. Assuming you can deduct all the interest, your after deduction rate on the mortgage is somewhere around 2.5% which shouldn't be too hard to beat even in a taxable account. When you do make it there, be sure to be tax conscious and take advantage of any losses through tax-loss harvesting, especially given your high (and presumably higher in the future) tax rates.

Principles of Tax-Efficient Fund Placement - Bogleheads

Tax Loss Harvesting - Bogleheads

You might also want to consider purchasing I-bonds through Treasury Direct. You can do $10,000 in each of your names each year.
Individual - I Savings Bonds

 

[NOLA Rob]

Those loan rates are ugly. I assume she's making the minimum payments on the lowest APRs and targeting the 8.5% first with all extra funds?

Yes they are and yes.

Once those are gone, I think you should focus solely on taxable investing vs. mortgage paydown. Assuming you can deduct all the interest, your after deduction rate on the mortgage is somewhere around 2.5% which shouldn't be too hard to beat even in a taxable account. When you do make it there, be sure to be tax conscious and take advantage of any losses through tax-loss harvesting, especially given your high (and presumably higher in the future) tax rates.

I tend to agree. Thanks for the advice and the links!

 

[LOL!]

Based on your answers, you are making a BIG mistake maxing out the Roth 401(k). You should be maxing out traditional 401(k)s and maxing out Roth IRAs. Then hit those student loans because the interest rate is so high.

Anyways, I wish to repeat: ROth 401(k) is a BIG MISTAKE in your situation.

 

[harley]

Yep, the others are right. At the very least I'd switch to the trad 401(k) and put the rest on the loans. Probably it wouldn't be a bad idea to cut way back on the 401(k) (just enough to maximize the match) and get the loans paid off as soon as possible. Then max out the traditional 401(k). JMO, worth what it costs.

 

[NOLA Rob]

Ok, you guys sold me. I'm going to switch to traditional 401k with at least 15k of the 17k going to traditional and keep about 2k going to the roth 401k. The concept of effective versus marginal tax rates was new to me. I pitched it to my wife and she agreed. Plus the extra 400+ a month going to the student loans should help. Thanks again!