[Editor's Note: This is my favorite kind of guest post. It isn't written by a financial professional, but by regular doctors, just like you, who made some smart financial decisions early on in their career. I heard their story and asked them to share it with you. Enjoy. They wish to stay anonymous, but I assure you I have no financial relationship with them.]
$242,000 in student loan debt.
For my wife and I, that was our combined debt burden upon finishing our respective residencies in June 2013. When we graduated from medical school in 2010, we actually had slightly less debt, but our Income Based Repayments during residency were not even enough to keep up with the 6.8% interest rate, so our debt continued to grow during residency. Considering that the American Medical Association reports that the average 2013 medical graduate has accumulated $169,901 in debt [That figure is lower than the AAMC reports-ed], many new graduates will find themselves in a similar situation. [Actually, $242K for TWO doctors is fantastic, reflecting the fact that wise financial decisions aren't new for these two-ed.] After doing a quick calculation and realizing that our $242,000 loan at 6.8% would grow by approximately $17,000 annually, we decided to make erasing debt our top priority. Ultimately, we were able to pay off our entire debt in five-and-a-half months by living below our means, funneling money into our loans aggressively, and obtaining an interest-free loan from the IRS. These are the steps we took to knock out our debt in less than six months.
We Lived Like Residents
Put simply, we did not change much about our lifestyle. We traveled more frequently than we had as residents, but we traveled on a budget by taking advantage of rewards points and other deals. Half-price trips to the nearest beach resort were in the budget; first-class flights to Tahiti would have to wait. More importantly, we avoided upgrading our major belongings: no new cars, no new house, no new designer wardrobes. Overall, we probably increased our standard of living by less than 20%. We decided that the time for living the high-life was after we became debt-free. In our minds, anything we bought while still in debt needed to be something we were willing to pay for with a loan at 6.8% annually.
Just to be clear, the IRS is not publicly offering interest-free loans to new attendings, but these “loans” are available by taking advantage of the tax code. First off, we worked as independent contractors. There are multiple opportunities to work as an independent contractor including locum tenens agencies, hospital staffing agencies, or even directly with hospitals if you are willing to negotiate on your own. Working as independent contractors (self-employed) was important, because no income taxes were withheld from our paychecks. Of course, the IRS still wants its money, and it wants its money on-time. Independent contractors are required to pay quarterly estimated income taxes in order to keep up with their tax liability throughout the year.
However, there is no penalty from the IRS as long as one makes estimated payments equal to 100% of the previous year’s tax liability (110% if AGI > $150,000)–even if one pays only a small fraction of one’s tax liability for the current year. This is commonly referred to as the safe harbor rule for estimated taxes. In our case, our tax liability for 2012 (our final full year as medical residents) was less than $12,000. Therefore, we were only required to make quarterly estimated tax payments of $3,000 to be protected under the safe harbor for estimated taxes.
This temporary underpayment of our income taxes allowed us to make loan payments of $246,000 in our first 5.5 months of employment with total gross earnings of $263,000 during that span. Over this period, we made just one $4,000 estimated income tax payment. We spent $13,000 on everything else, including disability insurance, health insurance, and expenses. In effect, we were able to put nearly 94% of our gross earnings toward our loan balance, while only paying 1.5% income tax during the time we paid off our student loan debt. In total, we made loan payments equal to $246,000 over 5.5 months—a total of only $4,000 in interest on our original $242,000 debt after finishing residency. We surely saved thousands of dollars in interest by being able to pay off our loans so quickly with the help of the minimal income taxes paid during that period.
Again, this process involved working as an independent contractor. I am not a tax professional, and am unfamiliar with the finer points of trying perform a similar maneuver as a W-2 employee by decreasing withholdings from one's regular paycheck. [No reason you couldn't do something similar as long as you stayed within the safe harbor-ed] This would likely be best discussed with one's HR department and/or a tax professional. Review IRS publications 505 and 17 for the relevant tax code regarding estimated tax payments and safe harbor rules.
We Opened Tax Advantaged Accounts To Lower Our Tax Liability
By opening a Health Savings Account (HSA, available if one uses a High Deductible Health Plan), and separate Solo 401(k) plans (one for each of us), we gained some flexibility to decrease our tax liability as much as possible. These plans must be opened before the end of the tax year, but can be funded up until April 15 of the following year. Opening these accounts before the end of 2013 allowed us to save all of our earnings until April 15, 2014 in a high-yield online savings account. At that point, we calculated how much we would be able to fund each tax-deferred account while still making our required year-end tax payment. The great part about this was that the more we funded our accounts, the lower our tax bill would be!
As an aside, we decided that a Solo-401(k) plan made more sense for us compared to other self-employed retirement accounts (SEP-IRA, for instance) because of the greater contribution amounts allowed for at lower incomes. We did not have enough income in the half-year after finishing residency to maximally fund either plan, but the Solo-401(k) allowed for several thousands more in contributions than the SEP-IRA would have. Also, having a Solo-401(k) allows for a more painless process to perform backdoor Roth IRA conversions in the future, which is an added benefit for self-employed physicians.
In the end, our year-end tax bill was several times larger than our previous year’s tax liability (don’t forget, the first quarterly tax payment for the current year is also due on April 15!). While writing such a large check to the IRS on April 15 was a bit distressing, it was nice of Uncle Sam to lend us that money interest-free for a few months to allow us to become debt-free!
[Editor's Note: Wasn't that awesome! I hope you enjoyed reading that success story as much as I did. The best part about their approach is that it is completely reproducible. Keep your debt burden down in med school, bide your time with IBR in residency, and then explode in a frenzy of debt payoff madness upon residency graduation. While you might not be able to get your loans paid off by Christmas, the average doctor with an average medical school loan burden ought to be able to have it done within a year or two. Even with a very high loan burden, three to five years is a very realistic time period.]
Could you do this? Why or why not? Keep your comments positive or I'll edit/delete them because I want to encourage this type of guest post submission.