As a veterinarian, one of the toughest financial decisions you have to make is whether to save for retirement and take advantage of compounding growth, or aggressively pay down student loans and become debt-free. Typically in order to achieve one of these goals, you have to sacrifice the other. But what if by saving for retirement you were actually able to lower your monthly payments? Sound too good to be true?
First, a little background about savings to retirement accounts (such as 401k, 403b, IRA, etc.). Contributions to these accounts are tax-deductible, meaning for every dollar you contribute you are able to reduce your taxable income. As an example:
Kelly is an associate veterinarian and is married to her husband, John. Their combined taxable income of $120,000 puts them in the 22% marginal tax bracket. If Kelly were to contribute 10% of her salary to her pre-tax 401k, this would reduce her taxable income to $108,000 saving them $2,640 annually in taxes ($12,000 x .22= $2,640). If John were to contribute to his 401k, this would reduce their taxable income, save taxes, and increase their retirement savings even more.
Many employers also offer company matches, which at a minimum you should be contributing enough to earn the company match, as foregoing this benefit is leaving money on the table.
How does this affect your student loan payments?
For those whose student loans are private or who are on a standard repayment plan, this strategy (while it’s still recommended to contribute to your retirement plan!) may not impact your payments. But for those who utilize or are considering an income-driven repayment plan, such as PAYE or REPAYE, your monthly loan payments are directly tied to your income. So by making contributions to your retirement plan, in effect you are lowering your discretionary income. With income-based repayment plans based on 10% to 20% of your discretionary income, the lower your discretionary income the lower your monthly payment will be.
To illustrate, let’s revisit Kelly and John from above. Let’s assume in addition to their combined $120,000 taxable income, Kelly still carries about $100,000 in student loan debt, and is on the PAYE repayment plan. They have 2 children together. To calculate her current monthly payments, we need 2 pieces of information:
- Kelly and Johns taxable income
- Kelly and John’s discretionary income
Their taxable income has been previously stated at $120,000. Their discretionary income is a bit more complex. According to the Department of Education, discretionary income is every dollar you make above 150% of the national poverty level, which is based on household size, as shown below.
So for Kelly and John, with a household size of 4, their discretionary income is calculated as follows:
$120,000 (household income)- $39,300 (150% poverty for household of 4)= $80,700 discretionary income
Calculating your monthly payment
Once we know their discretionary income, we then take this amount and divide by 12. In our example, this would be $6,725=($80,700/12). Since Kelly is using the PAYE repayment plan which bases monthly payments on 10% of discretionary income, this would mean a monthly payment of $672.50 ($6725 x 10%).
Now what happens to their monthly payments if they contribute 10% of their income to their retirement plans? By saving 10%, their household income drops to $108,000.
$108,000 (household income)- $39,300 (150% poverty for household of 4)= $68,700 discretionary income
$68,700, when divided by 12 and multiplied by 10%, equals $572.50 or a reduction of $100 per month in Kelly & John’s student loan payment. So by contributing 10% to their pre-tax 401k, in effect they are saving $2,200 in taxes, $1200 in annual student loan payments, and increasing their savings by $12,000 per year ( not including employer matches!).
If you’re not able to contribute 10% or more today, begin by contributing enough to get your full employer match ( if available) or start at a lower contribution, say 3%, and then increase your savings by 2% every year. You will be amazed how automating your savings will help you save more and spend less.
Does your practice not offer a retirement plan? Talk to your employer! Depending on the type, retirement plans can be easy to set up and allows the owner to reduce their tax liability, increase their retirement savings, and improve the recruitment and retention of their employees. You can also contribute to an IRA or Roth IRA in any year you have earned income. Consult with a qualified financial planner when determining which account works best for you.
Other Considerations for Student Loan Planning
Of course, there are numerous other factors which go into determining the best repayment plan for you.
Switching Repayment Plans– Typically it is best to avoid switching repayment plans. When you leave a repayment plan, the interest capitalizes, meaning it is added to your principal balance, increasing the total amount of interest and payments you will make over the life of the loan
Marital Status– For those who are married, depending on the repayment plan, it may be advantageous to file as married filing separately. Be sure you know the details of the repayment plan you choose and how filing status may affect your payments, and consult with a qualified tax professional before changing your filing status.
Forgiveness vs. Repayment– This is where planning for the future can really help out. Before you decide on your repayment plan, you need to ask yourself if you are working towards repaying your loans in full, or working toward forgiveness (typically after 25 years). A rule of thumb is if your debt is 1.5x your income or less (ex. $150k student loans and $100k salary) then working toward repayment might be best. For those whose debt is 2x their income or greater (ex. $200k student loans and $100k salary), working toward forgiveness might be the best bet. If working toward forgiveness, make sure you plan for the ‘tax bomb’ that will come once the loans are forgiven (discussed next).
**Tax Bomb– For those working towards forgiveness, you are most likely on an income-driven repayment plan. With these plans, many times the interest continues to accrue and the amount you owe increases every year. But since we are not working towards repayment, this should be ok. However, as the law is written today, once your loans are forgiven, the balance of your loans becomes taxable as income. Using the example of Kelly and John again, if Kelly’s student loan balance at the time of forgiveness is $150,000 and they are in the 22% marginal bracket, they can expect a tax bill of $33,000! Make sure you account for this when deciding between repayment and forgiveness.
** As of the publishing of this post, the American Rescue Plan Act will eliminate income tax on student loan forgiveness until January 1, 2026.
Because of the complexity surrounding student loans and how your future goals can affect this decision, we encourage you to speak with a qualified financial planner who can help compare different options and scenarios based on your unique circumstances.
At FivePoints Financial Planning, we are well versed in working with veterinarians who are striving to become practice owners. For more information on how to prepare your personal finances when considering ownership, please download our FREE e-book “The Veterinarian’s Guide to Personal Finance: 7 Actions to Take When You Want to Own Your Own Practice”
Andrew Langdon, CFP®, EA, MBA is a fiduciary fee-only financial planner who specializes in serving veterinarians in their pursuit of practice ownership.