Saving for Student Loan Tax Bomb--Good or Bad Idea? Forum

[AVBucks4239]

I graduated from law school with about $150,000 in student loan debt and have a job that pays around $50-55k. I qualify and have applied for IBR. I technically could pay the traditional 10 year payment (my expenses are very low because I don't have a car payment, rent is $225, etc.), but that would leave me with basically zero discretionary income (no money to invest or do anything socially).

Thus, I've opted for IBR, thus making my student loan payment about $375-400. This frees up about $1,300/month for me to invest/save.

There are two obvious risks to this:

(1) I start making enough money that I no longer qualify for IBR, and since all this interest has piled up, I end up paying a ton of money on my student loans; and,

(2) The tax bomb.

In a weird way, I don't think #1 will be an issue. I'm not overly ambitious and never plan on making a huge amount of money.

The tax bomb, however, scares me, because I have no idea how taxes work.

But here's my plan: start contributing the maximum allowable amount to my Roth IRA ($5,500 per year, or $458.33 per month). Automate this and never touch it for 25 year (which will be $137,500 in principal). Let the investments compound over time. When the tax bomb hits, pull the principal necessary to pay my tax liabilities.

I know this will substantially deplete my Roth, but I plan to have other assets secure my retirement (401k, traditional IRA, other investments, etc.).

Can some finance bros tell me to the pros and cons to doing this? I'd appreciate it because I don't want everything to be fucked in 25 years. Thanks.

[fats provolone]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

[Johann]

you're doing the right thing. planning for the tax bomb is dumb because its 25 years/20 years away. there is no telling what is going to be the law in that long. save your extra money and stick it in retirement and investments (real property included) and you'll be fine.

[AVBucks4239]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

Ya, my main idea is that I want to enjoy the tax free gains of the Roth before I have to pull the money. So I'd probably go with some aggressive index fund for 20-23 years, then switch to capital preservation when I'm close to having to pay Sasha Obama.

[fats provolone]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

Ya, my main idea is that I want to enjoy the tax free gains of the Roth before I have to pull the money. So I'd probably go with some aggressive index fund for 20-23 years, then switch to capital preservation when I'm close to having to pay Sasha Obama.

plus you just have no idea what the tax code will be. i mean that has positive and negative effects. the marginal rate could be like 90% by then. but you could take a sabbatical or defer income or something to reduce your rate in the bomb year. and if the tax bomb gets eliminated or w/e you are in great shape with a fat Roth

[BrazilBandit]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

Ya, my main idea is that I want to enjoy the tax free gains of the Roth before I have to pull the money. So I'd probably go with some aggressive index fund for 20-23 years, then switch to capital preservation when I'm close to having to pay Sasha Obama.

Make sure to avoid mutual funds or anything that will charge you a bunch of fees. With such a great timeline, diversify with as many ETFs (Exchange Traded Funds) and broad indexes as you can and let them sit - buy and hold leads to gold

[AVBucks4239]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

Ya, my main idea is that I want to enjoy the tax free gains of the Roth before I have to pull the money. So I'd probably go with some aggressive index fund for 20-23 years, then switch to capital preservation when I'm close to having to pay Sasha Obama.

Make sure to avoid mutual funds or anything that will charge you a bunch of fees. With such a great timeline, diversify with as many ETFs (Exchange Traded Funds) and broad indexes as you can and let them sit - buy and hold leads to gold

Ya, definitely avoiding mutual funds at all costs. Going with low fee index funds and ETFs and just letting them sit there for eternity.

[fats provolone]

the nice thing about PAYE/ibr is your interest keeps ballooning so even if your salary goes up you're probably still in hardship

[Tiago Splitter]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

Ya, my main idea is that I want to enjoy the tax free gains of the Roth before I have to pull the money. So I'd probably go with some aggressive index fund for 20-23 years, then switch to capital preservation when I'm close to having to pay Sasha Obama.

The gains aren't tax free if you're under 59.5 and you're pulling the money out to pay taxes. You'll also owe a 10% penalty on those gains.

Still I'd just save a lot and see what happens. If you're saving putting the first $5500 or whatever the max is for the year into a Roth IRA is a no-brainer.

[fats provolone]

sounds like a good plan to me. you get the tax free gains of the Roth while saving plenty for the tax bomb. what you lose out on is the subsequent tax free gains on that Roth principal from 2035-retirement, but (depending on how old you are) that might not be much at all.

Ya, my main idea is that I want to enjoy the tax free gains of the Roth before I have to pull the money. So I'd probably go with some aggressive index fund for 20-23 years, then switch to capital preservation when I'm close to having to pay Sasha Obama.

The gains aren't tax free if you're under 59.5 and you're pulling the money out to pay taxes. You'll also owe a 10% penalty on those gains.

Still I'd just save a lot and see what happens. If you're saving putting the first $5500 or whatever the max is for the year into a Roth IRA is a no-brainer.

you can withdraw the principal tax free though right? with his plan he'd have more than enough principal to pay the tax bomb.

[Tiago Splitter]

I assume he'd be tapping into some earnings. Roth limits will go up but he's not coming close to even paying the interest if he's only putting $400/month at a 150k loan. But yeah the principal comes out first and is tax and penalty free.

EDIT: Forgot he only needs enough to pay the taxes, not the whole debt. So it depends on where taxes are but OP probably won't need to tap into earnings unless rates go way up.

[fats provolone]

I assume he'd be tapping into some earnings. Roth limits will go up but he's not coming close to even paying the interest if he's only putting $400/month at a 150k loan. But yeah the principal comes out first and is tax and penalty free.

ya but he doesn't have to pay the loans just tax on the forgiveness. even if he pays only $400 a month for the life of the loan his balance is only gonna be like $400k. who knows what the tax rate in 2040 is gonna be but right now that'd be like $115k owed.

[Tiago Splitter]

I assume he'd be tapping into some earnings. Roth limits will go up but he's not coming close to even paying the interest if he's only putting $400/month at a 150k loan. But yeah the principal comes out first and is tax and penalty free.

ya but he doesn't have to pay the loans just tax on the forgiveness. even if he pays only $400 a month for the life of the loan his balance is only gonna be like $400k. who knows what the tax rate in 2040 is gonna be but right now that'd be like $115k owed.

yeah see my edit my mind went numb for a second there. The interest doesn't compound either so his balance should end up at more like 300k.

Anyways I'm all in on the PAYE train.

[AVBucks4239]

I assume he'd be tapping into some earnings. Roth limits will go up but he's not coming close to even paying the interest if he's only putting $400/month at a 150k loan. But yeah the principal comes out first and is tax and penalty free.

ya but he doesn't have to pay the loans just tax on the forgiveness. even if he pays only $400 a month for the life of the loan his balance is only gonna be like $400k. who knows what the tax rate in 2040 is gonna be but right now that'd be like $115k owed.

yeah see my edit my mind went numb for a second there. The interest doesn't compound either so his balance should end up at more like 300k.

Anyways I'm all in on the PAYE train.

The repayment estimator assumes a 5% raise every year (which seems high to me) and thus predicts I'll only have about $147k of loan forgiveness (i.e., almost my exact principal right now).

However, unless something unexpected happens (e.g., joining Big Law), I don't think a 5% raise is in the cards. So I'll likely have to more loans forgiven (I'm predicting somewhere around $250,000).

Even then, after 25 years, there will be at least $137,500 in principal in the Roth. The Roth minimum should increase to $6,000 some time here soon, then $6,500 probably in 10-15 years, so it will likely be more than that.

I imagine my tax liability will be somewhere around $75,000-$100,000 for my loans forgiven. But by that point, my Roth will be worth a total of about $375,000.

Then, even after I pull that $75,000, I'll still have $300,000 in the Roth. If I then continue contribute the max until I'm 65, then it's worth around $875,000. Add to that my 401(k) and I'll be just fine.

All in all, I think it's worth it, because it allows me to enjoy the fruits of compound interest and, more importantly, frees up a bunch of money so I can invest in other things (contribute to my 401k, save for house, etc.).

Glad this thread confirmed that I'm not insane.

[fats provolone]

are you married? if you marry someone who makes a good income and doesn't have student loan debt that could kinda fuck you over

[AVBucks4239]

are you married? if you marry someone who makes a good income and doesn't have student loan debt that could kinda fuck you over

Not yet. Already investigated and discussed this and, if we ever do get married, we will be filing separately.

[Tiago Splitter]

are you married? if you marry someone who makes a good income and doesn't have student loan debt that could kinda fuck you over

Not yet. Already investigated and discussed this and, if we ever do get married, we will be filing singly.

You'll need to backdoor the Roth contributions by first putting them into a traditional IRA and then immediately converting to a Roth if you end up married filing separately. Not a big deal if you don't have pre-tax IRA money but just an FYI. If they go back to pre-2010 rules you'd have no way to get money into a Roth.

[AVBucks4239]

You'll need to backdoor the Roth contributions by first putting them into a traditional IRA and then immediately converting to a Roth if you end up married filing separately. Not a big deal if you don't have pre-tax IRA money but just an FYI. If they go back to pre-2010 rules you'd have no way to get money into a Roth.

If you could put this in English and explain the reasons behind it, I'd appreciate it.

[LadyProspero]

Really don't want to sound like a noob, but could someone please explain to me exactly what the "tax bomb" is? I've seen it referred to over and over again in different threads but haven't been able to really pin down exactly what it is/how it happens etc.

[fats provolone]

You'll need to backdoor the Roth contributions by first putting them into a traditional IRA and then immediately converting to a Roth if you end up married filing separately. Not a big deal if you don't have pre-tax IRA money but just an FYI. If they go back to pre-2010 rules you'd have no way to get money into a Roth.

If you could put this in English and explain the reasons behind it, I'd appreciate it.

the Roth income cap for married filing separately is $10k. you'd have to be unemployed

[AVBucks4239]

Really don't want to sound like a noob, but could someone please explain to me exactly what the "tax bomb" is? I've seen it referred to over and over again in different threads but haven't been able to really pin down exactly what it is/how it happens etc.

If you go on IBR/PAYE and pay that for 20/25 years, then the forgiven loan amount is considered income in that 20th/25th year. So you have to pay tax on that.

[Tiago Splitter]

You'll need to backdoor the Roth contributions by first putting them into a traditional IRA and then immediately converting to a Roth if you end up married filing separately. Not a big deal if you don't have pre-tax IRA money but just an FYI. If they go back to pre-2010 rules you'd have no way to get money into a Roth.

If you could put this in English and explain the reasons behind it, I'd appreciate it.

the Roth income cap for married filing separately is $10k. you'd have to be unemployed

Meaning to fund a Roth you have to first put the money in a traditional IRA and then convert it to a Roth. Contributing directly to a Roth is effectively disallowed for people married filing separately.

Really don't want to sound like a noob, but could someone please explain to me exactly what the "tax bomb" is? I've seen it referred to over and over again in different threads but haven't been able to really pin down exactly what it is/how it happens etc.

When your debt gets forgiven after 20 years under PAYE or 25 years under IBR the amount forgiven is taxed as ordinary income.

[LadyProspero]

Really don't want to sound like a noob, but could someone please explain to me exactly what the "tax bomb" is? I've seen it referred to over and over again in different threads but haven't been able to really pin down exactly what it is/how it happens etc.

If you go on IBR/PAYE and pay that for 20/25 years, then the forgiven loan amount is considered income in that 20th/25th year. So you have to pay tax on that.

Ah got it, thanks for the clarification!

[AreJay711]

Really don't want to sound like a noob, but could someone please explain to me exactly what the "tax bomb" is? I've seen it referred to over and over again in different threads but haven't been able to really pin down exactly what it is/how it happens etc.

If you go on IBR/PAYE and pay that for 20/25 years, then the forgiven loan amount is considered income in that 20th/25th year. So you have to pay tax on that.

Ah got it, thanks for the clarification!

And it's due all at once. So if you have $100k being forgiven and your marginal tax rate is 35%, you'd be on the hook for $35k the year after your loan is forgiven. It'd be sensible for Congress to make some sort of payment plan for that but it's the Congress.

[AVBucks4239]

Meaning to fund a Roth you have to first put the money in a traditional IRA and then convert it to a Roth. Contributing directly to a Roth is effectively disallowed for people married filing separately.

Not sure how I missed this in all my research (which has been pretty substantial over the last six months). Thanks for letting me know before I boned myself.

Anyway, my GF already has a Roth. I've opened a Roth but haven't contributed to it yet.

I'm looking into similar Traditional Roth limits and it looks like I'm really boned here.

WTF should I do?