Start a traditional IRA or pay down student loan debt

[Druid]

Ok here is the deal...

I just accepted a job offer making $61,000 a year that starts after I graduate from my masters program. I will be contributing about 30% of my income to 401k to take advantage of the allowable max. I will already be in the traditional IRA phaseout MAGI range because I am single. My industry has healthy raises so here is my predicted path to complete traditional IRA phaseout.

Year 1 31,000(half year of work), but technically I will not earn enough to max traditional 401k so won't start IRA..
Year 2 61,000          max traditional IRA contribution based on phaseout: $4,950
Year 3 65,000          max traditional IRA contribution based on phaseout: $2,750
Year 4 70,000          max traditional IRA contribution based on phaseout: 0

I will have student loan debt of $35,000. Despite this debt I have already decided to max out my 401k with $18,000 a year as a minimum savings goal. I am wondering if its worth the hassle to contribute to a traditional IRA and later have to convert it to a ROTH when I have student loan debt with an interest rate just under 6 percent(less interest deduction). If I understand completely I should be able to deduct all of my student interest from my income in Year 1-3, so should I even consider loan interest in my retirement planning at this point? Alternatively I could focus on paying the debt down faster when the full interest is no longer deductible...

I have read a lot tonight about the Roth/IRA debate, but I am wondering if some of the financially responsible people on this site would even bother dealing with the traditional contributions and later Roth conversions considering that I also have debt of $35,000. It seems like a lot of work(again roth conversions) for a fund that will have contributions less than $8,000 after 4 years.

[wtjbatman]

401k contributions reduce your MAGI. If you're making 60k and maxing out your 401k, you will be well under the tIRA MAGI deduction phase out. In fact, according to your projected future income, as long as you keep maxing your 401k you will be able to deduct your entire IRA contribution for more than 4 years.

[Druid]

Wow........I totally got thrown off by the IRA being included in the MAGI. You are right that the 401k reduces the MAGI and I can invest in the traditional probably for at least several years...

Should I worry about the debt first? The combo of tax benefits from the traditional IRA and the student loan interest deduction sounds good..

If I max out both my traditional IRA and 401k I can probably pay the debt down in 5 years while still having at least 100k in retirement accounts.

[wtjbatman]

I don't know what the interest rate on your SL are, but odds are you should start investing now. I know I'm investing even though I have SL debt. The interest is low enough to make it worth it.

I like your 5 year plan.

[MDM]

Wow........I totally got thrown off by the IRA being included in the MAGI. You are right that the 401k reduces the MAGI and I can invest in the traditional probably for at least several years...

Should I worry about the debt first? The combo of tax benefits from the traditional IRA and the student loan interest deduction sounds good..

If I max out both my traditional IRA and 401k I can probably pay the debt down in 5 years while still having at least 100k in retirement accounts.

That appears to be a good plan.

One thing (among many) to consider: depending on your future income, you may be better off with Roth instead of Traditional for the IRA and even some of the 401k. 
If you do the maximum traditional 401k you will be in the 15% marginal federal tax bracket next year.  That makes a Roth more attractive than when you are in the 25% or higher brackets....

[SpareChange]

If I max out both my traditional IRA and 401k I can probably pay the debt down in 5 years while still having at least 100k in retirement accounts.

This is what I do. I max out the 401k and IRA, and anything left I use to beat down the student loan. 

[rmendpara]

Druid:

If you are able to max out your 401k in your first year of work, that's already a big win! Great job on the budget!

I think that's a huge win all by itself. I'd suggest the following in order, to keep things simple:

1) Build up an emergency fund ~3 months expenses
2) Max out 401k contributions each pay period
3) pay down your student loans.

[ once your loans are gone]
4) invest in taxable account

30k in loans isn't bad, and likely you'll be debt free within a few years or maybe less. Since the rate on your loans is around 6%, and your marginal federal tax rate will be 25% (60k-18k = 42k... squarely in 25% bracket), you'll save 315/yr from student loan interest deduction (30k x 6% = 2,100 x .25) = $525. That means your effective interest on student loan debt in the first year will be around (2100 - 525) = 1,575 / 30k = 5.25%.

A 5.25% GUARANTEED return is pretty darn good, plus you're already saving 18k, or 30% of gross income which is a GREAT start to your finances. In a few years time, you could be student debt free and likely have your savings rate much higher in the 40%+ range.

The other view would be to pay the minimum toward student loans and invest in the market, but your earnings is relaly the spread between aftertax investment returns and 5.25%. You can judge for yourself your risk tolerance, views/feelings about carrying debt, and short/medium term goals.

Even paying the minimum on loans and investing the rest is good, but only if you are disciplined and can actually commit to saving/investing rather than spending that extra money.

[Druid]

@ rmendpara

Thanks I appreciate your post! I am a numbers person so your calculations are helpful.

[Druid]

I have also been considering contributing to a Roth IRA in year 1,2 and 3 instead of the traditional.

A possible plan, please let me know if my reasoning is flawed, is that I will try to contribute 10k over the next three years to a Roth IRA. I am thinking that I can contribute 2k for 2014, 5.5k for 2015 when all my income is at 15%, and another 3k in 2016. I will be able to do all of these contributions while having no income in the 25% range, because of the student loan income deduction and pretax transportation benefits.

I am kind of OCD so I am hoping to keep all my investments at Vanguard(luckily my 401k will be vanguard!). I am hoping that if I start a Roth IRA while my taxable income is in 15% I can withdraw the 10k principal(tax free?)in 5 years from my Roth IRA to start my first taxable account(not IRA or 401k) with Vanguard since they have a 10k minimum. This would probably align when my student loans will be paid off.

I am not sure if this plan would be any better than investing in a low cost index fund with someone like Fidelity and eventually doing a transfer. It seems very likely that the 10k principal would be more valuable in a roth account than a regular fund account, but I find myself wondering how I am going to get a 10k lump sum payment to start my savings with Vanguard after the retirement accounts are maxed out. I also do not have the technical ability at this point to analyze if the traditional ira, and later roth conversion, is the better option even if the traditional only saves me taxes of 15%.

Any suggestions would be helpful as my personality does not allow piece of mind until I have a solid plan..

[MDM]

Numbers are good.  Correct numbers are even better.  One is taxed on taxable income, not adjusted gross income.

Taxable = Gross - 401k - student loan interest - deduction - exemption.

You can update for 2015 numbers, but using 2014 tax numbers and guessing at SL interest:

Taxable = $61,000 - $17,500 - $2,321 - $6,200 - $3,950 = $31,029, which is in the 15% bracket.

See the spreadsheet you can download from http://forum.mrmoneymustache.com/ask-a-mustachian/how-to-write-a-'case-study'-topic/msg274228/#msg274228 if you'd like to plug in your specific numbers (albeit using 2014 tax numbers for now).

[Druid]

Thanks MDM considering the exemptions and deductions and I will probably not be seeing 25% tax rates for a long while. Especially when my girlfriend and I have a child in a few years and I "take" the head of household status. Does this mean I should be thinking Roth? My plan is to retire at 45 so I will likely be in a position to do yearly roth conversions..

[MDM]

Thanks MDM considering the exemptions and deductions and I will probably not be seeing 25% tax rates for a long while. Especially when my girlfriend and I have a child in a few years and I "take" the head of household status. Does this mean I should be thinking Roth? My plan is to retire at 45 so I will likely be in a position to do yearly roth conversions..

Definitely think about Roth.  Whether to do Roth depends on your estimates of future income (which you can, to some extent, control) and future tax rates (which you can't control, so the "correct" answer is unknowable).

Some generic advice that one often sees is "do traditional while in the 25% or higher brackets, and Roth for the 15% and lower brackets."