Paying off student loan aggressively versus maxing out 401k?

 

My friend M. asked me following question: "Initially we were going to pay off the student loans aggressively and be done in 12-14 months. Now we are considering maxing out both 401ks to get the tax benefit. What makes more sense?"
 
 
The question is about prioritizing. Prioritizing maxing out 401k versus paying off loans.
But there are few more things which are in the priority list.
Usually after finishing residency most physicians have following major items where a lot of money has to go:

Loans
Student loan
House mortgage
Car payments
Insurances
Term life insurance
Disability insurance
Car/home/liability insurance
Savings
Health savings account
Savings for retirement
 
 
How to prioritize them?
 
One way is to prioritize by risk/consequences.
 
Prioritizing by risk means to prioritize by the most detrimental impact which have to be taken care off first. For example, if the breadwinner of the family dies, his/hers income should be replaced in some way.
 
The insurances can be grouped together and should be taken care of first:
 
1. Disability - will cover lost income.
2. Term life - will pay out a certain sum of money to cover lost provider, is necessary is the loss of provider will be financially very hard on spouse and/or child.
3. Car/home/liability insurances - helps with large assets in the worst case scenario if they need to be replaced, liability gives additional protection in case of unintentional harm to others.
 
After you are done with that, you can move to the group of Savings and Paying off loans:

1. Health savings account - for current or future disease related expenses.
2. Savings for retirement 401k, Roth IRA - if prioritizing by risk, tax-deferred accounts should be put before paying off mortgage because there is a better protection for retirement accounts in case of a bankruptcy - you get to keep your pension and retirement plan funds. In Tennessee tax-exempt retirement accounts, including 401(k) are protected. Roth IRA is protected up to $1,283,025 as of 2018. (This amount is adjusted every three years. For detailed information for your state go to NOLO.com.)
3. Car payment, house mortgage and student loan - I would group them together especially if they have similar low interest rates. They are not as well protected as retirement accounts.
 
 
But what if you say: Yes, prioritizing by risk is all good, but I personally think that the bankruptcy risk is very low for me. Maybe it will be better for me to pay off the student loans or mortgage first, before maxing out 401k and Roth IRA?
 
 
I already wrote about the difference of paying off the mortgage early versus investing the money that was used for the extra principal payments. Investing comes out ahead.

With current interest rates, it makes more sense financially to invest instead of paying off the mortgage early. If your interest on student loan is in the same ball park as the current mortgage rates, that would have the same effect. And by investing in a tax-deferred account like 401k, you will also receive tax savings. 


How much tax savings can you get?
 
If you contribute maximum ($18,500 for 2018) to the pre-tax 401k, you will save $5,920 in 32% tax bracket and $6,475 in 35% bracket. This is a significant amount which can be put into Roth IRA ($5,500 in 2018, see my post on how to use the back-door Roth IRA).

In 2018 most physicians will be in the 32% or 35% bracket.
If both spouses are maxing out their 401k, the tax savings are doubling and will be $11,840 in 32% bracket and $12,950 in 35% bracket, which is enough for maxing out both Roth IRAs.
You will not get those tax savings if you choose to contribute to Roth-401k (see here why I don't do Roth401k).
 


If you are 45 years old now and will make yearly contributions of $18,500 to your 401k, then at the age of 65 with 6% yearly growth and 3% inflation the balance will be $700,949. The number is of course approximate because returns will vary.
 
If you decide to pay off your student loans first, you will have less years left to contribute before tax. Dependent on how many years you will have left to contribute, you will forgo on:

19 years left:
401k balance at age 65: $643,297
Difference in total savings balance at age 65: $57,652
Lost tax savings, 1 year: $5,920
 
18 years left:
401k balance at age 65: $588,907
Difference in total savings balance at age 65: $112,042
Lost tax savings, 2 years: $11,840


But that is not all.

The employers contributions were not taken in account yet.

How much employers contribute is variable. The total maximum on total contributions (employee plus employer) is $55,000 in 2018 (or 100% of your salary, whichever is less).
This means that your employer could contribute up to $36,500 in 2018. 


In summary, if you compare paying off a low interest loan like a mortgage or a low interest student loan, versus investing in a taxed account, you will come out ahead with investing.

If you compare paying off a loan versus contributing to a tax-advantaged account like pre-tax 401k, you will not only come out ahead with investing but also have your savings grow fax free, you will save on taxes and you will get employer's contributions.




 

How to manage lifestyle inflation?

Lifestyle inflation - is it a problem of control?


Since I started working as an attending my expenses increased compared to the expenses during my residency.


Things that have changed since the new job:


1. I drive a more expensive car. The reason to buy a more expensive one was: I need a reliable car because I am expected to be at work as scheduled. Calling in because of a broken unreliable car is not professional. This expense makes sense and is justified. My old car was not reliable at all and when I traded it in for the new one a light smoke was coming out from under the hood. They still took it.


2. I buy more business/official looking cloths and shoes. This is also justified. I don't wear scrubs or a white coat and as a laboratory director I have to look accordingly to project competency and authority to both sides, personnel and administration. Old or non-professional looking cloths won't cut it.


3. I go on more expensive vacations. That is just for fun and I know that I am not overspending. I decided that spending $10,000 per year on vacation is fine.


Things that didn't change:


1. We still live in the same house we bought during residency. At the time of the house buying I read that most people buy a smaller "starter" house first and later move to a larger one. We decided not to do that and bought a right sized house from the start. 


2. We go out to eat about as frequent as during residency. The expenses didn't change much but the feeling has changed. Now I don't look at the prizes when I order. So the costs may have gone up a bit, but not significantly.


3. Nothing else changed really. Mostly we spend money on the same things as before, just the feeling is different, it just goes with ease and without any guilt feelings.


Some would say that I have a good self-control or will power. I would disagree. My will power is weak. But I have a trick.

I have worked out a decision process to use when spending money on something and that process became a habit.

Once you make a habit out of something, the will power is not necessary anymore.


How does this process work?


1. I have my major savings goal in mind and I update the status on how close I am to my goal once a month.

My major goal is to reach my savings magic number.  I update the balance monthly and I know where I stand. I know how fast or slow my progress is. I also know approximately how long I still need until I reach my goal. That gives me an idea on how strict I have to be with spending money.

2. I ask myself only one question before spending money on something.


Questions NOT to ask:

Do I need it? - is a wrong question. Your brain will always fool you into the need. The function of your brain is to keep you safe and to prepare you for any possible adverse situation.

Do I like it? - is also a wrong question to ask. I noticed that I like a lot of things.

Do I want to have it? - the same, most of the times you would want to have it.

The question to ask is this: 
How sad will it make me if I will die before doing that?


Here how the connection between savings goal and this one question plays its role: 
I know that I am not there yet and I still need a few years to complete the savings goal. I know that the job safety is not guaranteed and the way to the goal might get longer. But I also know that I will not live forever, that at some point I will die. That might happen before I reach my savings goal. 
All this information is balanced in the background. It is processed partially subconsciously and at the end I have my simple answer.  

The degree of sadness will tell you everything: if you should do it immediately or if you should wait and if wait then for how long.


I always dreamed about a romantic morning at the Ritz hotel somewhere in Europe with strawberries and Champagne for breakfast. 
After asking myself, how sad will it make me to know that I will die before I will get a chance to have my Champagne with strawberries for breakfast at a fancy hotel, the answer came immediately.
It would make me very sad. I didn't even want to wait for the hotel. Next day I went and bought fresh strawberries and Moscato vine (which I like more than Champagne).  I had my special breakfast every Saturday and Sunday for 2 months in a row.

Sometimes I think of going on vacation to Ireland. I spent 6 moth in Ireland and I like this country very much. When I ask myself how sad it would make me if I die before I go to Ireland, it makes me just a little bit sad, like 10 out of 100. So it is not an urgent item and I don't spend much time thinking about it at this time.

Another example:
My friend went to China. When I ask myself how sad will it  make me if I don't get to go to China before I die, the answer is surpizing: it will make me said if I do go there before I die. I don't know why. With a feeling like that I don't plan to go there.


Using this method makes the question about the lifestyle inflation mute and replaces it with a true personal value of things tailored exclusively for you.
But you have to be honest and only listen to you own feelings. It might not work for those who try to keep up with the Joneses. They have to work on their self worth and psychological self-sufficiency first.