Saving for retirement does not appear to be related to student loan payments and debt relief.
Fortunately, it is possible for many borrowers to keep money for retirement and get rid of student debt. In fact, saving for retirement can make federal student loan repayments easier.
The relationship between pension contributions, monthly payments and student loan forgiveness
Federal loan borrowers have the option of signing up for an Income-Driven Repayment (IDR) plan.
The IDR plans are popular because borrowers are more likely to make payments based on what they can afford than on what they owe.
In determining what a borrower can pay, the Department of Education calculates a borrower’s discretionary income. This calculation starts with the borrower’s Adjusted Gross Income (AGI) from their most recent tax return.
This is where saving for retirement comes in. Certain contributions to the pension plan are tax deductible. These tax deductible plans reduce a taxpayer’s AGI. The lower AGI means lower student loan payments for borrowers from IDR plans.
After all, a lower student loan payment means that more debt can be canceled when the borrower reaches the point of loan approval.
An example with actual numbers
Say I make $ 60,000 a year for the government.
I have a lot of federal student loans, so I sign up for an income-based repayment plan. If I choose the REPAYE plan, my monthly payments will be $ 341 per month, according to the Department of Education’s Federal Loan Simulator.
I realize I need to save more for retirement, so my employer needs to withhold $ 200 per paycheck for my retirement. Taxes vary from state to state, but for this discussion, let’s assume that my contribution of $ 200 per paycheck lowers my take-away wage by $ 150. After a full year, I’ll have $ 5,200 reserved for my retirement.
This retirement contribution lowers my AGI by $ 5,200. According to the credit simulator, the lower AGI means my monthly payment would be reduced to $ 297 per month. If I worked for an employer eligible for PSLF, the lower payments would mean that more debt would be canceled after ten years.
In summary, by putting money aside for retirement, I achieved the following:
- Lowered my monthly student loan payment
- Raised the money for my future
- I’ve cut my tax bill and
- Increased the amount of debt that can be forgiven.
In the months that I got two paychecks, I set aside $ 400 for retirement, spent $ 44 less on my student loans, and only lost about $ 300 on take-away pay.
Long term benefits:
This approach has significant long-term benefits. The $ 200 earmarked for each paycheck can be expected to increase over time. By the time you reach retirement age, your original contributions may have increased significantly, depending on your investment strategy. A hidden benefit of this approach is that borrowers start early with an interest in working for them rather than against them.
It is clear that some sacrifice is required to capitalize on the relationship between retirement, payments, and forgiveness. However, for those borrowers who can forego some income today, the future benefits can be substantial.
What pension contributions lower student loan payments?
Several different retirement accounts will achieve the goal of lowering IDR student loan payments.
In general, savers should look for accounts that are considered pre-tax or tax-deferred. In other words, choose a retirement account that has taxes paid on when the money comes out. instead of when the money goes in.
Common deferred tax accounts include: traditional IRA, 403 (b), 457, and most 401 (k) plans.
However, not all pension contributions lower IDR student loan payments. The pension plans that do not reduce IDR payments use after-tax contributions. The most common examples are a Roth IRA and a Roth 401 (k). These accounts are known as “after tax” because savers first pay tax on income and then deposit the money into their account. The advantage of Roth accounts is that the funds can be withdrawn tax-free in retirement. Unfortunately, Roth contributions do not affect the AGI calculations and do not lower student loan payments.
In addition to the contributions to the retirement account, there are other ways to lower your AGI …
Other ways to lower the AGI
Unfortunately, not all tax deductions lower Adjusted Gross Income (AGI).
Tax specialists call deductions that reduce the AGI deductions “across the board”.
In addition to the pension contributions, the usual deductions above the line include:
- HSA or MSA contributions (health savings accounts or medical savings accounts)
- Independent business costs and part of the independent taxes
- Student loan interest
For more information on over-the-line prints, see here.
If you are paying someone to prepare your taxes, it might be a good idea to discuss options for maximizing over-the-counter deductions.