By Dr. Jim Dahle, WCI Founder
Q. Could you please explain how a resident planning for PSLF should choose between contributing to a Roth account given the resident salary versus a traditional account to reduce AGI? What formulas should I be using? If it is okay with you, please provide a couple scenarios where Roth or traditional would be better? I know this is some basic formula driven tasks, but am completely new to finances.
A. Unfortunately, this is NOT “some basic formula-driven task.” It's actually one of the most complex areas of financial planning for physicians and something I generally refer people to a student loan advice specialist for. Student loans have never been all that easy to deal with, and they are becoming more complex as the years go by. There are still a few “no-brainers” out there. For example:
- If you have private student loans, you should refinance them every time you can get a lower rate.
- If you are single (or married to a non-earner) Revised Pay As You Earn (REPAYE) should be your default program for your federal loans during training.
- Forbearance on federal loans in residency is a bad idea.
But even these probably have a few rare exceptions. If you are married to another earner, one or both of you has student loans, and one or both of you is going for Public Service Loan Forgiveness (PSLF), chances are good that you should spend some time and money with a specialist as you leave medical school. The primary questions they will help you with are:
- Which IDR program should I enroll in?
- When should I refinance, if at all?
- How should we file our taxes (MFS vs MFJ)?
- Should we contribute to Roth (tax-free) or traditional (tax-deferred) retirement accounts?
Today we're just going to talk about just one of those questions, the final one.
Roth Is for Residents?
The Roth vs traditional debate is also a very complex area of financial planning that has been discussed in numerous posts on this site. There are no hard and fast rules, but there are a couple of rules of thumb that most people find useful:
- When in your peak earnings years, you should preferentially contribute to a tax-deferred account when offered the choice.
- When NOT in your peak earnings years, you should preferentially contribute to a Roth account when offered the choice.
There are, of course, exceptions to these two rules of thumb. For example, someone that expects a $10M IRA in retirement probably ought to be considering Roth contributions even during their peak earnings years. Likewise, a potential exception to the second rule of thumb occurs in residency when going for PSLF.IRA or 401(k), assuming availability and eligibility) is probably still the right move from a retirement and asset protection standpoint, if you use a tax-deferred account you may be able to both increase your REPAYE interest rate subsidy AND especially increase the amount forgiven tax-free under PSLF.
Which Matters More?
So which matters more, lowering your future tax bill or increasing the amount forgiven under PSLF? It likely depends on the assumptions you use, but let's run some numbers and see if we can provide some definitive help, at least for some people.
Let's assume a single resident making $60,000 per year who has no 401(k) available at work. He wants to put $3,000 in after-tax money toward retirement. He owes $300,000 in federal student loans at 6%, enrolled in REPAYE at the start of residency, and plans to do a four-year residency followed by six years as an academic making $250,000 taxable income per year. He is trying to decide whether to contribute to a traditional IRA or a Roth IRA. His marginal tax rate now is 22%. As an attending, he expects it will be 35%. In retirement, he expects it will be 32%. He is 30 years old and expects to withdraw all money contributed during residency at age 75. If you don't like any of these assumptions, I showed my work below so feel free to swap in your own numbers. I think they're reasonable and simplified enough for this exercise.
So this resident's decision is whether to contribute $3,000 to his Roth IRA or contribute $3,000/(1-22%)= $3,846 to a traditional IRA.
The Value of a Roth IRA for a Resident
Step 1 is to determine the marginal value of the Roth IRA over the traditional IRA. This part is relatively easy.
If he contributed $3,000 to a Roth IRA and it grew at 8%/year for 45 years, it would be worth
=FV(8%,45,0,-3000) = $95,761
If he contributed $3,846 to a traditional IRA and it grew at 8%/year for 45 years, it would be worth
=FV(8%,45,0,-3846) = $122,766 before tax and $122,766*(1-32%) = $83,481
The difference, $95,761 – $83,481 = $12,280 demonstrates why my general guideline over the years has been for residents to use Roth accounts preferentially.
The Value of Lower Payments
Step 2 is to determine how much lower your payments will be during residency as a result of contributing to a traditional IRA versus a Roth IRA. Unfortunately, this is a lot more complicated than the above calculation. In Income-Driven Repayment (IDR) programs like REPAYE, your payment depends only on your income and family size, not on the size of your debt or your interest rate. In this case, his family size is one and his adjusted gross income is $60,000 if he does the Roth contribution or $60,000 – $3,846 = $56,154 if he does the traditional contribution. What is his payment under REPAYE in both scenarios?
Using a student loan payment calculator, it looks like his REPAYE payments would be:
- Roth Contribution: $349/month
- Traditional IRA Contribution: $317/month
So the difference is $349-317 = $32/month. Multiply that out by 48 months and you get $32*48 =$1,536 in lower payments that he made. After residency in this scenario, the payments are going to be the same no matter what type of account he contributes to, and whatever is left will be forgiven via PSLF, so this $1,536 is the sum total of his savings. The question now becomes whether $1,536 NOW is worth more than $12,280 in four decades. We'll do that calculation next, but I hope if nothing else this exercise shows you how small all of these numbers are. As you can see, it just doesn't matter that much!
Making the Comparison
Step 3 is to compare how much more he ends up with using a Roth IRA to invest versus how much he saved with lower IDR payments. Naturally, we have to discount that money for the fact that he got it years earlier. It seems fair to me to discount it using the 8% number I'm assuming the investments will grow by. First, we'll account for the growth during residency:
=FV(8%,4,-32*12,0,0) = $1,730
Then we'll run that out another 41 years:
=FV(8%,41,0,-1730) = $40,590
The difference, $40,590 – 12,280 = $28,310 demonstrates that a resident going for PSLF is going to be better off contributing to a tax-deferred account than a Roth account, all else being equal. The value of the lower payments/additional forgiveness will outweigh the additional retirement savings. I think that's a fairly robust difference that will stand up to most reasonable changes to assumptions…except one, that the resident is actually going for PSLF.
What If the Resident Doesn't Go for PSLF?
Unfortunately, this calculation is going to be a lot more complicated. Obviously the difference the Roth makes will still be the same, but now the resident must pay back the loan. We'll need some new assumptions. Let's assume at the end of the four-year residency that the resident refinances the loan to 4% and pays it off over 5 years like a good little white coat investor.
What happens over the next 9 years?
These numbers aren't going to be exact due to amortization effects, but they should be close enough to give us the answers we need.
While contributing to a Roth IRA, the REPAYE payment is $349. The actual interest that accumulates is $1,500/month ($300,000*6%/12 months). ($1,500-$349)/2 = $576 is forgiven and $576 is added on to the loan. So at the end of four years, the resident has paid $349*48 = $16,752 and the loan stands at $576*48+$300,000 = $327,648. If he pays that off over 5 years, that will require a monthly payment of $6,034/month for 5 years.
While contributing to a traditional IRA, the REPAYE payment is $317. The actual interest that accumulates is $1,500/month ($300,000*6%/12 months). ($1,500-$317)/2 = $592 is forgiven and $592 is added on to the loan. So at the end of four years, the resident has paid $317*48 = $15,216 and the loan stands at $592*48+$300,000 = $328,416. If he pays that off over 5 years, that will require a monthly payment of $6,048/month for 5 years.
Not accounting for the time value of money over that 9 year period (to keep the math easy for me, trust me it won't matter much) we see that if he contributes to a Roth IRA he will pay an extra $16,752-$15,216 = $1,536 during residency and then pay $6,048-$6,032 = $12* 60 months = $720 LESS as an attending, for a total of $1,536 – $720 = $816 in additional payments. If we apply our 8%/year return to this for 36 years, we get:
=FV(8%,36,0,-816) = $13,030
As you can see, the value of using a Roth account over a traditional account is $12,280, so the total advantage of contributing to a traditional account under these assumptions is only $13,030-12,280 = $750….over 45 years. Essentially, it's a wash.
So Should the Standard Advice Change?
So is the standard advice that residents should use a Roth account preferentially wrong? No, I really don't think so for a couple of reasons.
First, if you're maxing out the Roth IRA account the Roth advantage is larger because now you're comparing $6,000 in a tax-free account to $6,000 in a tax-deferred account plus $1,692 in a taxable account, which will grow slower due to some of it being outside a tax-protected account.
Second, behaviorally speaking, I think people are more likely to save more on an after-tax basis using a Roth account.
However, there does need to be a major caveat here. If you are going for PSLF, probably going for PSLF, or even possibly going for PSLF, a tax-deferred account is likely to be the right move and if it turns out to be wrong, won't hurt you much.
What do you think? Would you use a tax-free or tax-deferred account in residency and why? Comment below!