Resident Retirement Contributions and PSLF: Pretax or Roth?

Saving for retirement, even as a resident, is a good thing. The absolute amount of money you can likely contribute is relatively small, but it does add up and over time it will compound to a larger amount. However, the most important reason to do so as soon as possible is to start the saving habit.

It’s important to make saving an automatic deeply-ingrained habit. It will serve you well when you make more money and help you make faster progress toward your savings goals of financial flexibility and a healthy retirement. If you think you should wait until you earn more money, the problem is that you can always spend more money, and some folks will simply need higher spending in order to make ends meet based on the decisions they’ve already made with regards to prior spending and borrowing, family planning, and the results of the match. So the most meaningful answer to the question of resident retirement savings is simply yes.

But if you can, let’s discuss the age-old question of pretax vs Roth.

The Options

In a traditional pretax account like the standard option for your work 401k or 403b, money is subtracted from your income in the year of the contribution. So you pay fewer taxes upfront. It then grows tax-free while in the account, and you’ll pay taxes on the distribution when you use it in retirement as if it were income.

Roth accounts are the opposite. You put after-tax money in, meaning you pay regular taxes on that money in the contribution year. The money also grows tax-free while in the account but then is also tax-free when you withdraw it.

Which contribution type is mathematically best has to do with your marginal tax rate during the contribution year while working vs during the withdrawal year in retirement. What’s important to realize is that mathematically, the two choices are equivalent when the tax rates are the same if the amounts contributed are adjusted on a tax-basis (ie, at a 10% marginal tax rate, $1000 pretax contribution is equivalent to $900 Roth, because the Roth has the taxes paid upfront).

The reason behind the idea that a resident should generally use a Roth option is because it’s assumed that you will earn less as a resident than you will want to spend in retirement (potentially true), not that you will simply earn less than you would as an attending (almost universally true).

Retirement Contributions and Student Loans

When it comes to student loans on an income-driven repayment plan, pretax contributions reduce your adjustable gross income, which reduces your discretionary income, which reduces your monthly payments the following year. Because PAYE/REPAYE uses a ten percent discretionary income calculation, every dollar you contribute reduces your payment by ten cents the following year (fifteen cents in the old IBR). If you achieve loan forgiveness via PSLF, then that bonus contribution match is truly extra free money on top of the PSLF windfall.

Additionally, if you are in REPAYE, the lower payments can result in more unpaid interest and thus a slightly better unpaid interest subsidy and lower your effective rate. Conversely, this would only matter if you did not get PSLF. Outside of this rate reduction, remember that lower monthly payments are really a good thing financially: they just mean less progress on your loans and more interest paid over time.

The impact here depends on how much you can contribute. If you have a high-earning spouse and can therefore max out a $19,000 contribution, for example, you’d save an extra $1,900 in payments the following year. That’s not chump change. But if you put $5k away? Just $500, or about $40 a month. Not necessarily anything life-changing there.

In contrast, Roth contributions have no impact.

How Taxes Work

Taxes are progressive. You don’t simply pay your marginal rate on all your earnings based on your total income. You pay the rate on each bucket of money as it fills up. But since pretax contributions are a deduction, they do reduce your taxes at the marginal rate.

So, looking at the chart, a single resident making $55k would be in the 22% bracket, and with the standard deduction, their effective tax rate is about 12%. Let’s say you then, as part of a married couple, wanted to retire on $100k a year? Well, with a $24k standard deduction that would actually get you a marginal tax rate of 12% and an effective rate of about 11% (using 2019 tax brackets as a guide). In this scenario, therefore, pretax could win right off the bat (the marginal rate is what matters here).

There are three important nuances here:

1. We don’t know what taxes will look like in the future.
2. Distributions are taxed as income, so not every dollar is taxed the same.
3. You may need less money in retirement than you think.

We don’t know what taxes will look like in the future

I suspect tax rates will overall be higher in the future, at least at the top marginal rates. The current rates are at historic lows, deficits are rising, and income inequality is reaching a tipping point. That doesn’t necessarily mean they’ll be higher at the level you end up retiring at, but it’s certainly a notch in the Roth column.

Distributions are taxed as income, so not every dollar is taxed the same

As we just discussed, taxes are progressive and each bracket is filled sequentially with rising income. So the first dollar pays almost nothing while the final dollar pays the full marginal rate. In retirement, you can utilize a combination of social security, Roth, and pretax money to minimize your tax burden. You do not need to pay taxes on an income of $100,000 in order to spend $70k after taxes in retirement like you would have during your working years if you have money in both types to utilize. You can use pretax at the lower tax brackets and Roth to fill in the rest to prevent paying the higher rates.

That’s one good reason to do a Backdoor Roth as an attending, even when you earn too much to contribute directly.

You may need less money in retirement than you think.

In retirement, you should have no debt and significantly decreased monthly expenses. No student loans. Real estate taxes, sure, but no mortgage. Probably no car payments, at least for a while. Maintaining a similar quality of life in terms of discretionary spending will be significantly less expensive even with some increased leisure spending.

The Fuzziness and Flexibility of Extra Money

The 10% PSLF “match” has nothing to do with tax savings. It’s extra after-tax money you get to play with the following year due to lower required monthly loan payments. So it’s letting you hold on to money you would have spent. That makes it fuzzy. But it also makes it valuable, because it’s money that you can do whatever you want with. You can certainly invest it by increasing your contribution to your retirement. You could even do that pretax again, getting a token 10% of that amount back the following year. But regardless, the money is a good reason to understand the idea of the time value of money.

The time value of money is the finance principle that money now is worth more than the same amount of money later due to its earning potential (i.e. it can be invested and earn interest). So while it’s possible, like in our above example, for this extra money to merely improve the tax inefficiency of using a pretax account when you hope to spend more in retirement, if it ends up a wash it still may be better to have that money now than later.

One thing to consider, outside of math, is simply where the extra money will help you more. If you do a good job saving for retirement, the few thousand bucks in changes related to tax optimization may not be meaningful because you’ll have more than enough anyway. On the flip side, having smaller IDR payments frees up money now on a monthly basis in these leaner years at the start of your career.

That’s putting money in your pocket to get rid of high-interest debt like credit cards, build up an emergency fund, save a little for an important purchase, make life and disability insurance affordable, or pay for your own HBO subscription (speaking of, have you priced out your options for own-occupation disability insurance yet? Because you need to).  My point is here is that it’s not always prudent to let the tax tail wag the living-your-life dog.

You can, of course, split the difference and invest some of your contribution in your work pretax account (say up to the match) and then whatever else you can afford into a Roth IRA.

Conclusion

It’s literally impossible to know what the correct choice is mathematically. Any calculation involves a ton of assumptions. It’s possible the machines will have taken over and everyone will be on a universal basic income and most tax revenues will come from the immortal cyborg of Jeff Bezos. It’s also absolutely possible that future tax rates will be sufficiently high that Roth becomes the optimal strategy regardless of the extra money pretax contributions can give you right now.

However, that doesn’t necessarily make it the right choice for you. Personal finance is personal. The increased cash flow now may be more valuable in practical life impact than more money later that you may not need or get to utilize.

Personally, if you’re really planning for PSLF, I think pretax makes a lot of sense (though Roth is never bad!). If you’re not planning for PSLF, then, by all means, these are almost certainly some of the best years of your career for Roth contributions. And lastly, if you’re struggling to make your IDR payments and don’t see how you could contribute to your retirement at all, then pretax may make it slightly more feasible for you.