The Best Student Debt Repayment Option for Those Seeking Financial Independence (FIRE)

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation. My recommendations in this area would be Will Butler or Joseph Reinke. 

In previous posts I have put some numbers behind the different student debt repayment options as well as included some non-financial reasons why I have chosen to go the income driven repayment route. For some background, please start here and here. Also if you’re unfamiliar with the idea of financial independence/early retirement, read this for context on what it means to me.

When I wrote those posts, I tried to keep the information general so that it would apply to as many people with student loans as possible. I really enjoyed doing the calculations and going through the considerations necessary to arrive at a conclusion, as it further cemented my decision. By the end, I determined that Revised Pay As You Earn (REPAYE) is the best option for my situation and likely the best option for the majority of those with student debt, but it is very important for everyone to run the numbers for themselves. I have to admit that for a long time I wavered back and forth on whether I truly wanted to continue on an income driven repayment plan when I have the money in cash that I can make my student loans disappear today. The numbers don’t lie though, and I am in this for the optimal financial outcome and not what is most convenient. I also have additional reasoning now that I fall back on when I’m in doubt.

Why REPAYE?

Let’s look at my situation and consider the best and worst case scenarios.

Best case: I make minimal payments, likely less than $100/month and almost definitely $0/month once at financial independence, for 25 years. At the end of 25 years my, now inflated, loan balance is “forgiven,” but I’m on the hook for paying taxes on the unearned income produced. I estimate that at this point my $97,000 initial loan balance will have grown to a little over $200,000 (6% interest rate reduced to an effective rate of 3%/year due to only half of accumulated interest being capitalized under the REPAYE plan), and I’ll be taxed at around 30% between federal and state taxes. This means I will have a $60,000 tax bill at the end of 25 years, plus only minimal (tax deductible) payments made throughout the course of the 25 years. What would I have to invest today to have $60,000 to pay this bill in 25 years at an average market return of 7%? About $11,000! So basically I could decimate my savings to destroy my $100,000 in debt today, OR I could invest only $11,000 of it in an S&P 500 index fund earmarked for my future tax bill. Sign me up for option 2!

Worst case: say 5 years from now all income driven loan forgiveness is repealed and everyone counting on it is left out in the cold. This is highly unlikely to happen without the people currently enrolled being grandfathered in, but this is the worst case scenario so humor me. In this situation, likely the income driven payment plans would still exist, but now no forgiveness at the end. Is this a disaster for my financial future? Not in my estimation. In this case I would remain on REPAYE (at the effective 3% interest rate as mentioned above) for as long as possible. A large loan with a 3% interest rate when market returns will likely be at least 6%/year and hopefully much more over the next 25 years, sounds like a great situation to me. In fact, if someone reputable approached me today and offered to loan me $1,000,000 at a 3% interest rate for the next 20-25 years, I would take that any day of the week! The student loan scenario is even better than the hypothetical loan though because all interest paid is tax deductible, which actually further reduces the effective interest rate.

To summarize, in the best case scenario I pay ~$70,000 over a 25 year period for a $100,000 loan. In the worst case scenario, I get a large tax deductible loan at a low 3% interest rate. Even the worst case scenario seems pretty good to me. I’m happy to plan for the worst and hope for the best here.

Narrowing the Focus

Alright, I’m already 700+ words in here and I haven’t even gotten to what I really want to discuss, so this may end up being a long one. Instead of looking at broad, more generalized scenarios like in my previous posts on student loans, I want to zoom in on those specifically shooting for becoming Financially Independent, Retired Early (FIRE). If you have read my blog for any length of time, it should be apparent that FIRE is my goal and that I believe it should be the goal of everyone, although with respect to their own life situations.

For people in the FIRE community, one of the foremost objectives is to reduce taxes by as much as possible to maximize savings rate. The primary way this is achieved is with maximizing tax deferred accounts (401k, traditional IRA, and HSA). This is paramount because for those of us seeking early financial independence, our tax rate will be much lower, possibly zero, after FI than before. This goes hand in hand with choosing REPAYE for student loan repayment. Since only roughly 30-40% of the final loan balance will be paid in taxes at the end for most people, keeping monthly payments as low as possible to have the maximum amount forgiven is optimal. Monthly payments are based on Adjusted Gross Income (AGI), for income driven repayment plans, so the lower your AGI, the lower your payment. AGI is reduced using the same strategies as reducing current tax burden, so we’re essentially killing two birds with one stone.

How Low Can You Go?

Yesterday, being the finance nerd that I am, I decided to play around with the student loan repayment estimator for a while (great use of a Saturday afternoon, right?) to determine how high of an AGI I could have to keep my monthly payment at $0. It turns out that $18,685 is the magic number for me being single and living in VA. I know what you’re thinking, that is pretty low. I agree, but keep in mind AGI is determined after subtracting contributions to tax deferred accounts. So in reality, I could have a gross income of $18,685 (AGI) + $18,000 (401k contribution) + $5,500 (traditional IRA contribution) + $3,400 (HSA contribution) = $45,585. This number seems a little more realistic. Having an AGI that low may not be feasible or desirable for many, and that’s understandable. The good news is that for every $10,000 that my income goes over the $18,685 threshold, my payment only increases by ~$88/month. That is, an AGI of $28,685 = a monthly payment of $88/month. An AGI of $38,685 = a monthly payment of $172/month, and you can extrapolate from there. As mentioned above, since the accumulated interest is much higher than these monthly payment amounts, every dollar I would pay would be interest. Normally this would be bad thing, but student loan interest is tax deductible so I’ll get a portion of what I pay back at the end of the year.

Everyone’s situation will certainly not be in the same as mine so I encourage you to play with the estimator yourself to find the magic AGI for you depending on your family size and state.

A Little Deeper

So for those trying to reach FIRE, a low AGI is already desirable so that is a big benefit, but there is another benefit from choosing REPAYE in this population. After financial independence, we will have much more control over our taxable income each year. It should be no problem keeping my AGI at $18,685 or lower and no longer having a monthly student loan payment. In addition, I can strategize with my income as the loan forgiveness date closes in. Since the total forgiven loan balance is taxable income, it is in our best interest to have as close to zero taxable income as possible in the year that the tax bill hits for the forgiveness to avoid the additional taxable income being taxed in a higher bracket. After financial independence this should be fairly easy due to much more flexibility. I would simply withdraw twice as much from taxable accounts in the year before (or withdraw money from a Roth IRA that has been rolled over from a Traditional IRA previously tax free) to cover my expenses for the year in which the tax bill hits, so that my taxable income, besides the unearned income, is at or very close to zero. Using this strategy and my estimated loan balance ~23 years from now, I determined that I would pay only an effective federal tax rate of 25.9% or $52,602 (on my total forgiven balance.

Keep in mind that this is based on today’s tax brackets. It is definite that the tax brackets and percentages for those brackets will be different in 23 years when I reach forgiveness, but I’m optimistic that this will benefit me more than it will hurt me. This is due to the steady increase in the lower tax brackets with inflation each year as well as a larger standard deduction and personal exemption.

That is my case for why REPAYE is the optimal option for those seeking FIRE with student debt and especially those with large amounts of debt.

Thanks for reading. What is your opinion on this matter? Are there considerations that I missed? What is your plan for your student debt?