I get annoyed when I see famous online financial "experts" make blanket recommendations to their audience. For example, Dave Ramsey's website recently posted an article that compares pre-tax 401(k) contributions to Roth 401(k) contributions. The article contains the following comment:
"But if I’m choosing between a traditional 401(k) and a Roth 401(k), I’d go with the Roth 401(k) every time!"
They are so convinced that the Roth 401k is the best option for everyone that they felt the need to end the sentence with an exclamation point. However, if you have federal student loan debt and you are targeting loan forgiveness, this is actually horrible advice that could cost you thousands of dollars. Why is this?
Making pre-tax contributions has two financial benefits. The first is that unlike Roth, they reduce your monthly student loan payments if you are on an income-driven plan like PAYE or REPAYE. Payments on these plans are based on 10% of your modified adjusted gross income (MAGI). So for every $100 you save in a pre-tax retirement account, you reduce your PAYE or REPAYE payments by $10. The less you are paying, the more you will have forgiven tax-free through PSLF. You could be paying almost $2000 less per year on your student loans by maxing out your pre-tax 401k. And this is after-tax savings, so if you adjust for taxes you really would be saving approximately $2500 per year. Even if you aren't maxing out your 401(k), these savings could go a long way towards other financial goals you may have such as saving for a wedding or a down payment on a house. You don't get those benefits with a Roth because you pay taxes on Roth contributions now, to avoid having to pay taxes on that money when you withdraw it down the road.
With pre-tax 401(k) contributions, in addition to the student loan payment benefits, you also save money now on taxes which puts extra money in your pocket for other financial goals. Let's say you are at a 30% marginal rate for your federal and state taxes. For every dollar you contribute to your pre-tax 401k you are saving 30 cents in taxes.
This combined benefit of paying less in taxes now AND paying less on your student loans has to be weighed against the fact that one day when you withdraw all of this pre-tax money in retirement, you are going to pay taxes on it. This is the opposite of the Roth where those withdrawals are tax-free. The concern with pre-tax contributions is that you are going to be hit with a higher tax rate on those withdrawals in retirement than the rate you would owe if you pay taxes on them now through Roth contributions. Will the difference in your tax rates between now and your retirement be high enough to offset the total current savings by making pre-tax contributions? This is highly unlikely. Especially if you make strategic Roth conversions later in retirement before RMDs and Social Security kick in.
As you can see, financial planning is not cut and dry. Blanket recommendations should be avoided. This is especially true when student loans are involved as student loan mistakes could cost you tens or even hundreds of thousands of dollars and the right decisions could save you that much.
At HCP Wealth, we specialize in financial planning for people with student loan debt. Our affordable, flat-fee pricing means we can work with anyone, regardless of current income or investment savings.