For those who qualify, PSLF can make an incredible difference in your long-term financial health by wiping away your student loans well before and for less money then you may be able to accomplish for yourself.
Due to the way income-driven repayment plan monthly payments are calculated, PSLF also acts as a government subsidy on your pretax retirement contributions. If you are currently using an income-driven repayment plan, every dollar you contribute this year to a pretax account will not only save you money on taxes this year (at your marginal tax rate) but will also “lower” your income for the year and then save you ten cents the following year.
Why?
Because IDR loan payments are calculated according to your discretionary income. Less income, smaller payments. For the two most common plans for recent borrowers, PAYE and REPAYE, it’s 10% (for borrowers on the old version of IBR, 15%).
For loans eventually forgiven via the PSLF program, every single dollar less you spend on your loans during the 10 years of repayment is another dollar that you save. This amounts to a partial federal match on your 401(k)/403(b)/traditional IRA contributions and an automatic 10% return on your investment.
Theoretically, the relatively low income of a resident is generally ideal for making post-tax Roth contributions (either to a Roth 401(k)/403(b) or Roth IRA). This is because doctors are felt to likely want to retire on more annual “income” than they earn as a resident, so that paying taxes now in a lower bracket is better than paying taxes later when in a higher bracket (not to mention the possibility that tax brackets may be higher across the board in the future). That said, a life in retirement without constant car payments, a mortgage, or student loans would cost far less than a similar lifestyle as a young professional. The bonus “match” is a reason to consider making pretax contributions against the more conventional wisdom.
Note that even without PSLF, pretax contributions still reduce monthly payments. For people actually paying off their loans, lower payments generally aren’t a good thing (just more money spent in the long term on interest), but in the setting of REPAYE and negative amortization, the lower payments would also mean more unpaid interest and thus more unpaid interest waived via the 50% unpaid interest subsidy and a lower effective interest rate.
For example, if you were somehow able to max out your personal contribution ($19,000 in 2019), then you would reduce your payments by $1,900 the following year in PAYE/REPAYE (or $2850 in IBR). That’s $158 per month. And that kind of savings over 10 years definitely adds up.
Extending $0 payments
Things can get really creative. If you were lucky enough to have a working spouse who earns enough to pay for your family’s living expenses (or are so hyper frugal that you live in the call room and eat saltine crackers pilfered from the ER for the majority of your meals), you could even pull a clever trick and zero out your loan payments for your first two years of residency. How?
Well, if you read my beloved (free) book, this helpful post about consolidating your loans after graduation, or remember the bit about this from a few paragraphs ago, you’d recall that payments under an IDR plan are calculated as 10% of your discretionary income based on last year‘s taxes under PAYE/REPAYE. A graduating medical student / new intern generally made little to no money the prior year and can secure zero dollar monthly payments for their intern year that nonetheless still qualify for PSLF.
Now here is where the retirement contribution component comes in. Normally, a second-year resident who consolidated after graduation will make payments based on a tax return that combines the last half of their fourth year of medical school and the first half of their internship. This means that it essentially based on a half year of income, say $25-30k instead of $50-60k.
Discretionary income takes your adjusted gross income and subtracts 150% of the poverty line. So PAYE = 10% (AGI – 150% x Poverty Line) / 12. For example, in the contiguous 48 states in 2019, the poverty line for a single person is $12,490. As a practical matter, this means that a single borrower must make around $19k per year in order to have a non-zero payment. Therefore, if you can put away enough money in the first half of your intern year to reduce your gross income to the poverty line, then your payments the following year will also be zero dollars.
(Note: it’s actually probably better to have a token payment of a few dollars so that there is an easier paper trail of payments for PSLF as well as no chance of your servicer not applying the 0.25% interest rate reduction for setting up auto-pay).
Roth conversions can be a useful hedge
Consider a Roth conversion to be a hedge. Now if a light bulb just went off and you’re thinking you could place money in a pretax 403b/401k to get the income-lowering benefits for IDR/PSLF purposes and then immediately convert that money to Roth in order to take long-term advantage of their low current income bracket, that’s not how it works. The IRS treats the Roth conversion amount as income for your taxes, so it undoes the income lowering.
But while in REPAYE, you could make pretax contributions during your early residency years as we discussed to get the lowest effective rate possible. Then, during your final training year—if you now know you’re not going for PSLF and have enough money saved up—do a Roth conversion and pay the taxes at your low resident income bracket before you become an attending. A senior resident and an intern are in the same tax bracket unless a lot of moonlighting is taking place, so you don’t lose money that way due to higher marginal taxes. In this setting, you’d likely follow this with a student loan private refinance, so the increased AGI for the following year wouldn’t matter.
Take Home
So, in addition to providing uncapped tax-free loan forgiveness, don’t forget that PSLF also functions as a government subsidy on your retirement accounts as well.