Pay Off Loans or Save for Retirement?

Q: I’m still paying off student loans. How can I save for retirement at the same time and make the most out of it?

A: A common dilemma for physicians is deciding between paying off student loans faster and saving more for retirement. There are several reasons why you should think about keeping your student loans as long as you can.

First ask yourself, “Do I need to use the money right now?” If the answer is yes, then it’s foolish to pay off your student loans faster. This really has to do with your personal monthly expenses and cash flows. If you need to use the money for short-term goals, you’ll be in trouble coming up with the cash to do so, because once you write that check to your loan company, you’re not getting that money back.

Second, what is the average interest rate on your student loans? If it’s low enough (less than 5%) then you might be better off investing more money for your retirement and generate higher returns than the loan interest rate you’re paying.

Third, while it’s admirable to be debt free by paying off your student loans faster, psychologically you probably won’t feel very good knowing that you’ve hardly saved anything for retirement when you’re 45 years old.

On the other hand there are great reasons to pay down the student loans faster instead of saving more.

First, once you pay them off you’ll increase your monthly cash flow and cut your monthly expenses.

Second, your income is probably too high to qualify for the student loan interest tax deduction, so you don’t get many tax breaks by keeping the student loan.

Third, paying off your student loans gives you a guaranteed rate of return whereas investing doesn’t. For example, if your interest rate is 5%, you know that an extra payment generates a 5% rate of return for you, but you have no idea what rate of return you’ll get by investing.

Finally, for most physicians there’s a great psychological value to paying off student loans.

So it depends on what’s most important to you as to whether you should pay down student loans versus invest more.

Suppose you take a balanced approach and pay down your loans while also saving for retirement. What’s the best way to save for your retirement? This depends on many factors, such as your income, whether you are an independent contractor or employee, your personal monthly expenses and so on.

Here are general guidelines for what vehicles you should use to save for retirement:

If you are an employee, your first choice should be to save in your company or group’s 401(k) plan and sock away as much as you can ($17,000 is the limit for 2012 if you’re under age 50). Many plans match part of your contribution so it’s like “free money,” but only if you contribute. Another nice feature is that your contributions are pretax so you’ll lessen your tax burden.

If you max that out, then you should consider saving in a traditional IRA or Roth IRA. You can make traditional IRA contributions regardless of income (though they may not be tax deductible), but if your income is too high you won’t qualify for Roth IRA contributions. One strategy here is to make nondeductible IRA contributions and then convert them to Roth IRAs.

Finally, if you want the most flexibility simply invest in a taxable account. By doing this you can use this money if you really need it without worrying about penalties for early withdrawals from 401(k)s.

If you’re an independent contractor, the easiest retirement plan to set up is a SEP IRA. You can contribute a maximum of $50,000 this year and it is tax deferred just like an employer 401(k). You’ve got wide open investment options and minimal administrative work. After that you can fall back to the IRA/Roth IRA contributions and, finally, use a taxable account.

One word of caution here: many financial advisors will tell you to invest only in cash value life insurance as your only investment vehicle. While there are some legitimate reasons to use cash value life insurance, beware of the high fees associated with this strategy.

Have a question? Write to PMD’s team of experts at ljoszt@hcplive.com

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