Author Topic: Help with student loan strategy  (Read 5129 times)

mit

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Help with student loan strategy
« on: September 08, 2015, 08:46:53 PM »
I wanted to start by thanking everyone for all that I have learned from reading through this website as well as through many posts in the forums. I was hoping to gain a little more advice on my particular situation...

We have a household income of roughly $225k and take home about $150k after taxes/benefits.

Our main liability besides a $268k mortgage is $168k worth of student loans. The breakdown is as follows:

Student Loans $168,817.25
6.613%  - $14,270.91

3.15-6.55% - $79,864.35

2% - $7989.54

4.565% - $17,281.10

3.15-6.55% - $49,411.35

Our current minimum payment for the loans monthly is: $2131. In terms of savings, we are able to set aside about $3k per month. My question is in regards to how to utilize this $3k. If we were to put it all towards the student loans, I calculate that we will be able to completely pay them off in roughly 3 years (total monthly SL payment of $5131). The other option would be to completely invest the $3k (max out both of our 401k & max a backdoor roth for each). The latter option would put the student loan repayment out to 9 years. Obviously, if all the loans were paid off we would be able to devote a little over $5k per month towards 401k, roth, & taxable. Is it worth sacrificing the three years in order to be completely debt free? Or is it foolish to lose the three years of investing in order to maximize the debt repayment. Thanks for any input that can be offered.

seattlecyclone

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Re: Help with student loan strategy
« Reply #1 on: September 08, 2015, 08:59:37 PM »
I don't think 2-4% is "hair on fire" territory. 6% is getting there. Your high income means that pre-tax retirement savings is a particularly attractive option. What if you decided to max out the 401(k)s, put the rest of your money toward the 6% loans, and wait until they're gone to contribute to start a backdoor Roth IRA? How long would it take to get rid of just the higher-rate loans?

johnny847

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Re: Help with student loan strategy
« Reply #2 on: September 08, 2015, 09:02:02 PM »
It really depends on your personality. Are you okay with hanging on to debt and investing the difference? Or would you rather have the peace of mind of having it paid off?

Rationally speaking, it's better to invest once you've paid off your high interest rate loans. I agree that 4% isn't hair on fire territory while 6% is getting there.

mit

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Re: Help with student loan strategy
« Reply #3 on: September 08, 2015, 09:15:57 PM »
seattlecyclone:

At the current proposed extra payment, the 6% loans would be done in 1 year. If I were to max out the 401k's that would mean about $1000 of extra payments. Under this situation the loans would be paid off in roughly 62 months.

johnny847:
I guess it seems to me that 3 years isn't extremely long to have all SL debts paid in full. From that perspective, it brings me peace of mind. My ultimate goal is to be FI by 49. I'm 33 currently and so am looking for the optimal strategy for achieving this goal.

johnny847

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Re: Help with student loan strategy
« Reply #4 on: September 08, 2015, 09:21:57 PM »
seattlecyclone:

At the current proposed extra payment, the 6% loans would be done in 1 year. If I were to max out the 401k's that would mean about $1000 of extra payments. Under this situation the loans would be paid off in roughly 62 months.

johnny847:
I guess it seems to me that 3 years isn't extremely long to have all SL debts paid in full. From that perspective, it brings me peace of mind. My ultimate goal is to be FI by 49. I'm 33 currently and so am looking for the optimal strategy for achieving this goal.
If you want mathematically optimal, investing the difference is your answer.
But being able to sleep well at night is more important than what's mathematically optimal.

You could choose an in between option. You have a little under $900 left after minimum payments. Maybe use like $450 of that for extra payments and invest the other $450?

JustGettingStarted1980

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Re: Help with student loan strategy
« Reply #5 on: September 09, 2015, 06:16:27 AM »
Hi,

Maxing out your 401K will give you approx $5000 back in taxes, for a return of 5000/18000 = 28% at your tax bracket. This does not include any potential employer matches, which would of course greatly increase that percentage.

In any case, 28% return is much higher than 6.6%, so max out the 401K.

After that, I'd tackle the Student Loans like a maniac. I personally would hit everything over 3%, and use the remainder as a negative bond from then on in my investing portfolio.

Best of Luck,

JGS

johnny847

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Re: Help with student loan strategy
« Reply #6 on: September 09, 2015, 06:34:28 AM »
Hi,

Maxing out your 401K will give you approx $5000 back in taxes, for a return of 5000/18000 = 28% at your tax bracket. This does not include any potential employer matches, which would of course greatly increase that percentage.

In any case, 28% return is much higher than 6.6%, so max out the 401K.

After that, I'd tackle the Student Loans like a maniac. I personally would hit everything over 3%, and use the remainder as a negative bond from then on in my investing portfolio.

Best of Luck,

JGS

Not really. Unless all of the 401k withdrawals are done at 0% (unlikely though still possible) some taxes will simply be paid back later.
It's still a good return on your money for most people because most people drop tax brackets in retirement (and even if they stayed in the same bracket it's still a good deal because 401k contributions are for the marginal dollar) but to say your return is equal to your marginal tax rate is simply not true (barring exceptiomexception above).


Furthermore it's possible that tax rates will rise in the future.

JustGettingStarted1980

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Re: Help with student loan strategy
« Reply #7 on: September 09, 2015, 09:20:53 AM »
Hi Johnny,

We disagree a bit here. Forgive me my simplifications as I was trying to make a point.

This is an Early Retirement Blog.

General consensus here is to convert 401K to Roth via 5 Year Roth Pipeline in early retirement. If you remain in the 15 % income tax bracket at that time (<75K), income is actually taxed at 15% of course, and Long Term Capital Gains Taxes are actually 0%.

He would get an immediate 28% return the year of his 401K contribution that will compound tax free over time...sure he will pay taxes eventually, but Much Much Less than he would pay now. I'll leave the math to smarter folks than myself (where's MDM when you need him?)

Some Links for backup:

Thanks Seattle!
https://seattlecyclone.com/accessing-your-retirement-accounts-early-yes-you-can/

Go Curry

http://forum.mrmoneymustache.com/taxes/taxes-in-early-retirement-(gocurrycracker-links)/

johnny847

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Re: Help with student loan strategy
« Reply #8 on: September 09, 2015, 12:00:07 PM »
Hi Johnny,

We disagree a bit here. Forgive me my simplifications as I was trying to make a point.

This is an Early Retirement Blog.

General consensus here is to convert 401K to Roth via 5 Year Roth Pipeline in early retirement. If you remain in the 15 % income tax bracket at that time (<75K), income is actually taxed at 15% of course, and Long Term Capital Gains Taxes are actually 0%.

He would get an immediate 28% return the year of his 401K contribution that will compound tax free over time...sure he will pay taxes eventually, but Much Much Less than he would pay now. I'll leave the math to smarter folks than myself (where's MDM when you need him?)

Some Links for backup:

Thanks Seattle!
https://seattlecyclone.com/accessing-your-retirement-accounts-early-yes-you-can/

Go Curry

http://forum.mrmoneymustache.com/taxes/taxes-in-early-retirement-(gocurrycracker-links)/

I am well aware of the Roth pipeline. If you want you could find numerous threads where I cite the Roth pipeline in response to questions of 401k vs taxable for early retirement.
I am also well aware that this forum is for an early retirement blog. To insinuate that I don't realize the latter despite my almost 2000 posts in this forum is ridiculous.

All I'm saying is you made it sound like it was a 28% return, with ZERO mention of any future tax obligations. To claim former without the latter is the same as presenting just the pros of a plan with non of the cons when you are fully aware of the cons. This is disingenuous at best.
I know the taxes paid back are usually less. Notice how I said some taxes will be paid back, not all.
« Last Edit: September 10, 2015, 04:36:41 PM by johnny847 »

Radagast

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Re: Help with student loan strategy
« Reply #9 on: September 09, 2015, 11:48:26 PM »
Hi Johnny,
He would get an immediate 28% return the year of his 401K contribution that will compound tax free over time...sure he will pay taxes eventually, but Much Much Less than he would pay now.
All I'm saying is you made it sound like it was a 28% return, with ZEEO mention of any future tax obligations. To claim former without the latter is the same as presenting just the pros of a plan with non of the cons when you are fully aware of the cons. This is disingenuous at best.
I have to agree with JustGettingStarted1980 here. An additional 28% to compound tax free will overwhelmingly result in mit having more money, regardless of what future withdrawals are taxed at.

seattlecyclone

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Re: Help with student loan strategy
« Reply #10 on: September 10, 2015, 12:14:25 AM »
Hi Johnny,
He would get an immediate 28% return the year of his 401K contribution that will compound tax free over time...sure he will pay taxes eventually, but Much Much Less than he would pay now.
All I'm saying is you made it sound like it was a 28% return, with ZEEO mention of any future tax obligations. To claim former without the latter is the same as presenting just the pros of a plan with non of the cons when you are fully aware of the cons. This is disingenuous at best.
I have to agree with JustGettingStarted1980 here. An additional 28% to compound tax free will overwhelmingly result in mit having more money, regardless of what future withdrawals are taxed at.

False. If the withdrawals are taxed at 28% or more, Roth contributions would be better than traditional IRA contributions.

Radagast

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Re: Help with student loan strategy
« Reply #11 on: September 10, 2015, 12:28:08 AM »
Hi Johnny,
He would get an immediate 28% return the year of his 401K contribution that will compound tax free over time...sure he will pay taxes eventually, but Much Much Less than he would pay now.
All I'm saying is you made it sound like it was a 28% return, with ZEEO mention of any future tax obligations. To claim former without the latter is the same as presenting just the pros of a plan with non of the cons when you are fully aware of the cons. This is disingenuous at best.
I have to agree with JustGettingStarted1980 here. An additional 28% to compound tax free will overwhelmingly result in mit having more money, regardless of what future withdrawals are taxed at.

False. If the withdrawals are taxed at 28% or more, Roth contributions would be better than traditional IRA contributions.
OK I just checked and you are correct. I made a conceptual math error, I must be tired.

Radagast

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Re: Help with student loan strategy
« Reply #12 on: September 10, 2015, 12:45:47 AM »
I still feel compelled to say this. It looks like you are spending $6,000 per month exclusive of housing, investing, and interest. Your best option is probably to free up an additional $3,000 in savings by reducing lifestyle expenses. It wouldn't be MMM if no one pointed that out.

mit

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Re: Help with student loan strategy
« Reply #13 on: September 10, 2015, 02:24:33 PM »
I still feel compelled to say this. It looks like you are spending $6,000 per month exclusive of housing, investing, and interest. Your best option is probably to free up an additional $3,000 in savings by reducing lifestyle expenses. It wouldn't be MMM if no one pointed that out.

well we're already saving 53% of our income. adding an additional $3k would raise it to 71% and unfortunately that is not feasible at this time for us. But believe me whatever extra funds we may have will all be going towards these cursed loans.

MDM

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Re: Help with student loan strategy
« Reply #14 on: September 11, 2015, 03:16:05 PM »
Our current minimum payment for the loans monthly is: $2131. In terms of savings, we are able to set aside about $3k per month. My question is in regards to how to utilize this $3k. If we were to put it all towards the student loans, I calculate that we will be able to completely pay them off in roughly 3 years (total monthly SL payment of $5131).
Yes, 3 years it is (assuming the average interest on the 3.15-6.55% loans).  For others interested, there is a spreadsheet you can download at http://www.vertex42.com/Calculators/debt-reduction-calculator.html that gives results such as:
CreditorBalanceRatePaymentCustom
Student Loan #1 14,270.91 6.61%$191.83
Student Loan #2 79,864.35 4.85%$1,005.38
Student Loan #3 7,989.54 2.00%$90.13
Student Loan #4 17,281.10 4.57%$215.22
Student Loan #5 49,411.35 4.85%$622.02
168,817.25 2,124.58
Monthly Payment 5,124.58 .
Initial Snowball3,000.00
Strategy:2
Creditors inOriginalTotal InterestMonths toMonth Paid
Chosen OrderBalancePaidPay OffOff
Student Loan #1 14,270.91 220.71 5Feb-16
Student Loan #2 79,864.35 4,588.17 24Sep-17
Student Loan #5 49,411.35 4,971.16 32May-18
Student Loan #4 17,281.10 1,882.73 35Aug-18
Student Loan #3 7,989.54 390.99 36Sep-18

Quote
The other option would be to completely invest the $3k (max out both of our 401k & max a backdoor roth for each). The latter option would put the student loan repayment out to 9 years. Obviously, if all the loans were paid off we would be able to devote a little over $5k per month towards 401k, roth, & taxable. Is it worth sacrificing the three years in order to be completely debt free? Or is it foolish to lose the three years of investing in order to maximize the debt repayment. Thanks for any input that can be offered.
You could follow these rules of thumb (and note the 10-year T note interest is currently ~2.2%):
In the lists below, thinking "first your 457 (if you have one), then your 401k and/or 403b" wherever "401k" appears is likely correct.   
Also, differences of a few tenths of a percent are not important when applicable for only a few years (in other words, these are guidelines not rules).   
   
WHAT   
0. Establish an emergency fund to your satisfaction   
1. Contribute to 401k up to any company match   
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.   
3. Max HSA    
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level   
5. Max 401k (if 401k fees are lower than available in an IRA, swap #4 and #5)   
6. Fund mega backdoor Roth if applicable   
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.   
8. Invest in a taxable account with any extra.   
   
WHY   
0. Give yourself at least enough buffer to avoid worries about bouncing checks   
1. Company match rates are likely the highest percent return you can get on your money   
2. When the guaranteed return is this high, take it.   
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.   
4. Rule of thumb: traditional if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between (or see   
   http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/
   if you want even more details on that topic.)
5. See #4 for choice of traditional or Roth for 401k   
6. Applicability depends on the rules for the specific 401k   
7. Again, take the risk-free return if high enough   
8. Because earnings, even if taxed, are beneficial   

heitzrun

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Re: Help with student loan strategy
« Reply #15 on: September 11, 2015, 04:24:19 PM »
The real question is would you borrow money at 3-7% in order to save it?

mit

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Re: Help with student loan strategy
« Reply #16 on: September 11, 2015, 07:54:39 PM »
Our current minimum payment for the loans monthly is: $2131. In terms of savings, we are able to set aside about $3k per month. My question is in regards to how to utilize this $3k. If we were to put it all towards the student loans, I calculate that we will be able to completely pay them off in roughly 3 years (total monthly SL payment of $5131).
Yes, 3 years it is (assuming the average interest on the 3.15-6.55% loans).  For others interested, there is a spreadsheet you can download at http://www.vertex42.com/Calculators/debt-reduction-calculator.html that gives results such as:
CreditorBalanceRatePaymentCustom
Student Loan #1 14,270.91 6.61%$191.83
Student Loan #2 79,864.35 4.85%$1,005.38
Student Loan #3 7,989.54 2.00%$90.13
Student Loan #4 17,281.10 4.57%$215.22
Student Loan #5 49,411.35 4.85%$622.02
168,817.25 2,124.58
Monthly Payment 5,124.58 .
Initial Snowball3,000.00
Strategy:2
Creditors inOriginalTotal InterestMonths toMonth Paid
Chosen OrderBalancePaidPay OffOff
Student Loan #1 14,270.91 220.71 5Feb-16
Student Loan #2 79,864.35 4,588.17 24Sep-17
Student Loan #5 49,411.35 4,971.16 32May-18
Student Loan #4 17,281.10 1,882.73 35Aug-18
Student Loan #3 7,989.54 390.99 36Sep-18

Quote
The other option would be to completely invest the $3k (max out both of our 401k & max a backdoor roth for each). The latter option would put the student loan repayment out to 9 years. Obviously, if all the loans were paid off we would be able to devote a little over $5k per month towards 401k, roth, & taxable. Is it worth sacrificing the three years in order to be completely debt free? Or is it foolish to lose the three years of investing in order to maximize the debt repayment. Thanks for any input that can be offered.
You could follow these rules of thumb (and note the 10-year T note interest is currently ~2.2%):
In the lists below, thinking "first your 457 (if you have one), then your 401k and/or 403b" wherever "401k" appears is likely correct.   
Also, differences of a few tenths of a percent are not important when applicable for only a few years (in other words, these are guidelines not rules).   
   
WHAT   
0. Establish an emergency fund to your satisfaction   
1. Contribute to 401k up to any company match   
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.   
3. Max HSA    
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level   
5. Max 401k (if 401k fees are lower than available in an IRA, swap #4 and #5)   
6. Fund mega backdoor Roth if applicable   
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.   
8. Invest in a taxable account with any extra.   
   
WHY   
0. Give yourself at least enough buffer to avoid worries about bouncing checks   
1. Company match rates are likely the highest percent return you can get on your money   
2. When the guaranteed return is this high, take it.   
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.   
4. Rule of thumb: traditional if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between (or see   
   http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/
   if you want even more details on that topic.)
5. See #4 for choice of traditional or Roth for 401k   
6. Applicability depends on the rules for the specific 401k   
7. Again, take the risk-free return if high enough   
8. Because earnings, even if taxed, are beneficial   

Wow MDM thanks for that detailed breakdown. It was very informative. One follow up question I had was: is it an oversimplification to always choose Roth when your choices are between a non deductible IRA and a backdoor Roth? I don't see our income going below the limit for being able to deduct anytime soon so is it always gonna be a backdoor Roth for us? Furthermore, should we always do a traditional 401k as opposed to Roth 401k due to higher income levels so as to save on taxes now?

MDM

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Re: Help with student loan strategy
« Reply #17 on: September 11, 2015, 09:37:00 PM »
Wow MDM thanks for that detailed breakdown. It was very informative. One follow up question I had was: is it an oversimplification to always choose Roth when your choices are between a non deductible IRA and a backdoor Roth? I don't see our income going below the limit for being able to deduct anytime soon so is it always gonna be a backdoor Roth for us? Furthermore, should we always do a traditional 401k as opposed to Roth 401k due to higher income levels so as to save on taxes now?
You're welcome.  The spreadsheet tools help a lot. :)

Backdoor Roth starts with a nondeductible IRA contribution.  If you leave the money in the IRA, you pay tax on any increased value when you withdraw, even after age 59.5.  If you move it to a Roth, you pay no tax on any value increase after the move when you withdraw after age 59.5 - so no, doesn't seem an oversimplification.

The traditional vs. Roth question cannot be answered correctly without considering total (federal + other) marginal rates both at contribution and at withdrawal.  We can make assumptions.  For example: if we assume a married couple will have an annual gross income between $28,750 and $85,200 in retirement, that puts them in the 15% federal bracket.  That's not an unreasonable assumption (and a similar assumption can be made for singles), and leads to the rule of thumb mentioned in Why #4.

But not everyone fits the assumptions behind rules of thumb, so caveat user.  See the link also given in Why #4 for more details.