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Make $43,000 by not paying your medical school debt


During residency, it is economically advantageous to maximize your investment in a Roth IRA versus reducing your interest burden by paying off an equivalent amount of medical school debt. How much better? For each dollar you shift to a Roth IRA, you could be eight dollars better off in the long run. Contribute $15,000 while your income is low and it could be worth $120,000 or more when you retire. Here I will explain why the Roth IRA is a good financial decision for young doctors-in-training.


What is a Roth IRA?

The Roth IRA is retirement plan for people who don’t make much money. You can deposit up to $5,500 per year of earned income. Your maximum deposit limit goes down quickly once your income exceeds $116,000 (i.e. attending-level salary). It is pretty likely that the only time in your life you will be able to exploit the benefits of a Roth IRA is before you complete your residency.

Roth IRAs have a wide range of investment choices, but the best long term returns are likely to come from investments in equities (stocks), mutual funds, and ETFs. Because the earnings in such an account are reinvested, they compound until you retire and your investment can grow a lot.

Perhaps most importantly, your ultimate withdrawal of money from a Roth IRA is tax-free. In contrast, your withdrawals from a regular IRA will be taxed as ordinary income at a combined state and federal rate, which approaches 50%.


Why is a Roth IRA good for resident physicians?

Because their income is low enough to qualify and high enough to make the maximum contribution. Because of its tax-free treatment, the eventual returns on the Roth IRA are high enough to more than outweigh extra interest you will pay if you delay paying back your medical school loans.

In other words, you will end up with much more money if you contribute modestly to a Roth IRA during residency instead of repaying loans with that cash.


Sounds too good to be true. Show me the numbers.

Let’s walk through an example. Say you save up $10,000 over 5 years. Let’s divide that money into two $5,000 investments. The first investment is today and the second investment is 5 years from now, when you are no longer eligible to put money in a Roth IRA. Remember, when you finish residency, your attending-level income makes you ineligible.

Let’s make some reasonable assumptions:1

Interest rate on medical school loan 6%
Annual market return on investments2 7%
Tax rate on money withdrawn from Roth IRA 0%
Tax rate on money withdrawn from regular IRA/401K 50%
Age at start of residency 26
Age at retirement 65

We have two options for our $10,000 of savings:

  1. Deposit the first $5,000 in a Roth IRA today, and 5 years later use the second $5,000 to repay part of your loan.
  2. Use the first $5,000 to repay part of your loan today, and 5 years later deposit the second $5,000 in your regular IRA.

If you pursue option 1 and compound a $5,000 investment in your Roth IRA by 7% annually for 39 years, you could withdraw $69,974.10 when you retire. The net value of option 1 is therefore $69,974.10.

However, option 1 postpones repaying $5,000 of your loan for 5 years. This loan accrues $1,691.13 of interest during this period. Such interest could be avoided by paying $5,000 toward the loan on day 1.

If you pursue option 2, by paying $5,000 of your loan you save $1,691.13, which is the interest that would have accrued if you pursued option 1. At year 5 you invest the second $5,000 into a regular IRA. This investment compounds for 34 years (39-5) to a total of $49,890.57. Withdrawals from regular IRAs are taxable (~50%) so you end up with $24,945.28. Therefore the net value of option 2 is therefore $1,691.13 + $24,945.28 = $26,636.41.

The value of option 1 minus the value of option 2 equals $43,337.69. Stated another way every dollar you diverted into your Roth IRA is worth $8 in the long run.

Download the spreadsheet here.3 You can make different assumptions about tax rate and investment returns and see how this changes the payoff.


Limitations

In real life, it is hard to save $5,000 a year. And when your income finally rises it is easy to convince yourself you deserve some long-deferred luxuries. Putting money away in a retirement seems even stranger to a medical student who is facing immense debt.

The average amount of debt US medical students graduate with is $176,000 (source). This includes nearly $58,500 in interest charges over the life of the loan. If the physician repays this debt over 10 years, they would pay $1,954 every month. Now add rent, food, taxes, and other costs of living. Quite a challenge!

Nevertheless, the Roth IRA is a good choice whether you can save $5,000 or only $100. It is hard to beat decades of compounded gains that can be harvested tax free.


Conclusion

It is economically superior to contribute money every year during residency to your Roth IRA, instead of using the same money to accelerate repayment of your loans. The penalty you pay in extra interest is far lower than the gains you get by exploiting the special tax-free treatment of the Roth account.

If your total contribution to a Roth IRA reached $15,000 this could be worth an extra $120,000 in the long run. That’s significant enough to impact other goals like a home mortgage, dream vacation, or child’s college education.

The point of this discussion is to raise your awareness of this issue. Just the way you get your medical advice from a professional, you should get your tax, legal, investment, and accounting advice from professionals, not from me. What I hope to do is encourage you to ask the right questions.


  1. In our model, returns after year 5 are identical. This means one key driver of the different outcomes is the extra money you have in your Roth IRA account at start of year 5. This produces a significant benefit for the Roth IRA under any assumed non-negative long-term rate of return. The second driver of the difference is paying taxes on your regular IRA withdrawals. This produces an equally significant advantage for the Roth IRA under virtually any tax rate assumption including the lowest federal tax bracket of 10% for families earning less than $18,450. In summary, the Roth strategy is dominant. 

  2. Our return assumption is deliberately low to withstand scrutiny. When you are making a judgment regarding returns over a 35 to 40 year period you always need to use long-term data. One of the classic sources for this information is Ibbotson (80+ years). History suggests 10% is a defensible rate, and the 7% we chose is conservative by any measure. Remember, the 1926 - 2009 period in the Ibbotson study included the Great Depression and the recent Great Recession. It is not a cherry-picked period of high returns. 

  3. Thanks to @dreinertsen for making the spreadsheet, providing substantial revisions to this post, and elaborating on assumptions behind the model.