Saving for retirement vs paying down student loans (Pt. 1)
Part one of a two part series on saving for retirement vs paying down student loans.
“I’ll wait until I pay off my student loans before I start worrying about saving for retirement.”
- A person who is not going to have a good time in retirement
The average physician has $251,600 in student loan debt after graduating medical school. With the average interest rate on these loans hovering between 5-7%, many physicians feel a sense of urgency in paying off all their loans before saving for retirement.
This is a bad strategy for one fundamental reason: compound interest. Compound interest is a powerful mechanism that you want working for you, not against you. The best strategy to achieve this is a combination of paying down your loans (yes, somewhat aggressively) AND contributing to your retirement savings.
This all boils down to simple math: if you can invest your money and get between 8-10% return, while refinancing your loan down to 3-4% interest, compound interest is working for you. If you simply put off saving until your loans are paid off, you are quite literally leaving hundreds of thousands of dollars on the table.
Here’s how:
A quick lesson on compound interest
Let’s use three examples to illustrate how much your retirement journey can differ depending on when you start saving. Let’s assume all our physician friends finished residency at age 30, make $300,000/yr, and plan to work for 30 years. We can also assume they all made an equal 8% per year on their investments.
Kate will be the fast-saver, she saved early and often but also stops early to spend her money on other things. Kate saved 30% of her salary for 15 years and then stopped. Kate would have saved $1,350,000 and retired at age 60 with an investment portfolio totaling $7,751,799.
Ben will be the average-saver, who saved consistently through his working years. Ben saved 20% of his salary for all 30 years. Ben would have saved $1,800,000 and retired at age 60 with an investment portfolio totaling $6,796,993.
And then there’s Bryan, our friend from college who didn’t read this post and started saving late thinking he could “catch up.” Bryan waited until he was 45 to start saving 60% of his income. Bryan would have saved $2,700,000 and retired at age 60 with an investment portfolio totaling $4,887.381.
The cost of waiting is startling. Bryan was able to save twice as much as Kate but, by waiting so long, he cost himself over $3,000,000 in retirement, not to mention living off a strict budget the second half of his career.
Everyone likes talking about the next best investment strategy but no one seems to want to take the unsexy, lucrative path of starting early and compounding over time.
Back to our example, Bryan’s investment strategy would have to outperform Kate’s by over 60% just to be close to catching up. Investing always involves some level of risk and there is no way to increase the returns that significantly without taking on some significant additional risk. (Here’s a helpful link showing our math in this example if you’re interested.)
So where should you put your savings?
The short answer is your 401(k) retirement account; however, our clients are generally eligible for a number of tax-efficient retirement accounts including a Roth IRA. The 401(k) is our preferred account to start with because of the obvious reason that these accounts are typically sponsored by your employer, but there are also a few other benefits:
Tax Deduction - If your income is $300,000 and you maximize your 401(k) ($19,500 in 2020), you save money at your marginal tax rate. For 2020 the federal tax for someone making $300k is 35% and for NC residents (where we’re based), the income tax is 5.25%. So the tax deferral benefit is 40.25% * $19,500 = $7,848.75 in tax savings.
Tax-Deferred Growth - In a normal brokerage account, investors are subject to capital gains when they trade out of different investments, as well as being taxed on any dividends and interest paid to them by their different investments. This could range from your normal income tax rates for short-term capital gains to up to 20% for long-term capital gains (depending on the amount). It is safe to say that avoiding these taxes allows more dollars to stay invested and at work for retirement plan savers.
Let's compromise, you may not be able to save the full $19,500 yes, so how much should you save?
If you have a 401k match available, you should at least be maxing the amount your employer has offered to match.
Otherwise, a great rule of thumb for a resident is to save 10-15% of your income for retirement.
Once you’re making your full salary (post-training) you should be maxing any tax-advantaged account possible ($19,500 for 401(k) and $6,000 for Roth IRA). If you don’t have a 401(k) program with your employer, a great “level 1” goal would be to at least max your Roth IRA.
Looking ahead to your life as an attending or in private practice, you’ll be making much more money and therefore have more money available to invest. The average rule-of-thumb is to continue saving 15%, but high-earners’ social securities get capped at $137k, so maxing these accounts will likely leave a lot of additional dollars to allocate. The remaining money would go into things like:
Brokerage accounts
Outside, non-qualified investments
When you do contribute to your 401(k), there are fees to keep an eye on
We make sure to regularly monitor the fees paid by our clients across different investments, insurances, and loans to ensure they are getting the best deal. 401(k)’s can be specifically tricky to compare because of the different layers of fees involved:
Plan/Admin Fees - These are generally the expenses charged by the administrator of the plan. We can see these fees paid by employers, passed onto the employees, or a combination of the two. This usually comes in the form of a percentage of assets charged on the plan as well as a bill at the plan level.
Participant Fees - Charged directly to the participants, we see these as monthly, quarterly, or annual expenses charged within each plan participant’s account.
Expense Ratios - This is the cost inside of each investment that the participant chooses.
Fees are always an important consideration to make and we have even seen the very rare plan where the math does not make sense for clients to participate due to high fees. This is definitely the exception to the rule and we almost always encourage clients to participate up to the maximum allowable to the IRS.
This is only half the plan
Now that you have a good understanding of the power of saving early and how to do it, we need to get the interest rate and principal on your student loans down to really take advantage of a compounding retirement account.
We’ll talk about dealing with student loans in detail in our next post, so make sure to hit that subscribe button and get it straight to your inbox.
What’s on your mind?
We’ll be sharing tidbits of wisdom like this with any subscriber every two weeks, along with deeper dives for our clients every month or so.
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Talk soon,
Chris
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Fortress Physicians by the Numbers
🏡 42 Physician Households as Clients
💰 $680,000 Avg Household Income
👩 Average Age 44
💸 $3.25 Million Net Worth
📈 29% Average Savings Rate
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