Part 1 of this series discussed the path that many take from being bright-eyed; bushy-tailed [young people] to being bright-eyed, bushy-tailed new BigLaw attorneys with a ton of student loan debt hanging over their necks.
Part 2 of this series attempted to convince you that if, in fact, you have a ton of student loan debt hanging over your neck, you ought to make the first Decision involved with the Great Student Loan War: don’t turn into a spendy-pants lawyer that finds themselves having made minimal progress 3 years out when many people start thinking about leaving BigLaw (or are forcibly shown the exit).
This Part 3 will explore the second Decision involved with the Great Student Loan War. As a very friendly reminder, this post gets more into the weeds than some of the previous posts. Please read The Fine Print. None of the below constitutes legal advice, and you, dear reader, are not my client. Some aspects of this post have been slightly modified since its original posting. I’m still finding my sea legs on this blogging thing.
Having decided that you are not going to spend your money frivolously, how do you balance the desire to win the War against other wealth-building activities?
- Do you go all-out in the effort to win the War? In this extreme approach, every spare penny goes to the loans. What type of insane individual would bet their money on the stock market, or on real estate, or on any other investment, with those student loans hanging over your neck? I’ll call this the Dave Ramsey Approach.
- Do you take the view that Greed is Good, Debt is Good, and your money is better off in other investments? In this extreme approach, the only difference between you and the person that took the wrong path on Decision #1 is that you’re spending all of your money on your investment of choice. You’re still just making the minimum on your student loan payments (or perhaps making a bit extra, with the idea of paying the loans off in 8 years or so). I’ll call this the Gordon Gecko Approach.
- Or do you take some flavor of a middle-of-the road approach, where you do a combination of early debt repayment and investing in other ways? I’ll call this the Balanced Approach (not really).
You might expect that I’ve set these options up to make it obvious that the right path is the third option. And you’d be completely right! So let me first explain why, when it comes to the Great Student Loan War, you (probably) shouldn’t be an acolyte of either Dave Ramsey or Gordon Gecko.
Why shouldn’t you take the full Dave Ramsey, foregoing all investments in favor of killing your debt?
- Taken to the full extreme, you would not even make 401(k) contributions, particularly because no BigLaw firm of which I am aware provides any 401(k) matching for its associates. (If there are any firms that do provide a match out there, let me know!) I’ll discuss this more in a later post, and you can find countless pontifications of the importance of taking advantage of this tax-advantaged space throughout the personal finance blogosphere. But the critical issue here is a simple matter of tax arbitrage and understanding the basic idea that, as a BigLaw associate (or other high-income earner) a tax deferred is a tax reduced and, potentially, a tax never paid. Even if you are married and the only income earner in your household, as a first-year associate, you will be in a high federal income tax bracket–and, unless you’re a member of the BigLaw Financial Master Race (i.e., people practicing in Texas, where national BigLaw firms generally pay the “market” salary scale despite there being no state income tax and everything costing about half as much–really, the only opportunity for Geographic Arbitrage available to a BigLaw attorney, and by no means easy to break into as a non-Texan), you will be in a high income tax state, too. Your Traditional 401(k) contribution is, accordingly, going to have an almost-instant 30%-or-greater rate of return because of saved taxes, with only a possibility of some of that being recaptured in the future. Don’t be an idiot. Max out your 401(k) contributions.
- You also would not make a back-door Roth IRA contribution. Again, more on that in a future post, but you and your spouse (even if your spouse does not work) is each eligible, on an annual basis, to take advantage of a ridiculous, yet clearly-blessed, loophole in the tax code to contribute $6,000 (in 2019) of cash to a Roth IRA. There is no up-front tax savings, here, because the entire point of Roth IRAs (and Roth 401(k)s) is that they are funded with after-tax money. But the money grows tax-free, forever (sure, you could be concerned about change in law risk on this, but at some point, one just has to live life). Don’t be an idiot. Max your Roth IRA contributions.
- You either would not contribute to a Health Savings Account (or HSA), or you would contribute to an HSA but then immediately withdraw those contributions to fund current medical expenses. Wrong! HSAs are the steroids of tax-efficient investing, if you use them properly. They are tax-deductible and grow tax-free, like traditional 401(k) contributions, and if they are eventually used for qualified health expenses, the withdrawals are tax-free too. Under current law, you can save receipts indefinitely to make that tax-free withdrawal. Even if that receipts-in-a-shoebox (or a Dropbox, as the case may be) loophole eventually is fixed, hopefully, you are going to be old some day. I wouldn’t bet on Medicare-for-All being enacted. So access to a massive pile of tax-free money to deal with your future medical expenses–having had the benefit of years of tax-free compounding–isn’t something you should be giving up.
- There are some less obvious errors that channeling Dave Ramsey would inflict. Maybe you have a kid (or two or a dozen, you do you), or are going to have a kid in the future, and you live in a state that gives a tax deduction for contributions to a 529 educational savings plan. You miss out on that. As I discuss below, if you’re taking a Balanced Approach you may choose not to put money in a 529 while your loans outstanding–that was what I decided to do–but if you’re going Dave Ramsey, you wouldn’t even think this through. Same for saving for a down payment on a dwelling–which, again, you may or may not decide to actually do, but at least think it through appropriately.
Why shouldn’t you invoke Gordon Gecko, ride the lightning, and let the power of leverage work for you?
Well, I’ve never met a bankrupt man without debt. Let’s be less glib about it, though.
There is no doubt that there are very solid mathematical scenarios that back up the idea that, as a rule, you will come out ahead financially if you keep debt on your balance sheet and invest aggressively. Those mathematical scenarios depend on many variables, including the effective interest rate on your student loans, what you assume about the all-in rate of return you will receive on your investments, what you assume about inflation, and whether student loan forgiveness may eventually apply to your situation. Most BigLaw attorneys should not be factoring loan forgiveness into the equation unless you know, with absolute, 100% certainty, that you will transition to an eligible public service job relatively early in your career, and then stick out the mandatory forgiveness timeframe (newflash–you’re not going to get to this level of certainty). But there is no doubt that a BigLaw attorney would likely be able to get an attractive enough interest rate through refinancing their student loans (an option that was not available to me when I graduated Law School, at least until I had reduced my loan balance to a small enough amount that it wasn’t really worth it) that Math would say, over a long time horizon, you’re likely to be better off fully invested.
The glib response to this is “if I liked Math, I wouldn’t be a lawyer” (another newflash, though–most lawyers actually need to be at least nominally proficient in, like, algebra, which is really as far as you need to be in order to do the math I’m talking about here). That’s a horrible excuse to not think through the numbers of your individual case. But what I can tell you, definitively, is that Math utterly fails to deal with many truths of being a BigLaw attorney.
- From all else follows this: The Gordon Gecko Math is based off a long-term time horizon. But for MOST BigLaw attorneys, BigLaw is NOT A LONG-TERM GIG. And that’s true EVEN IF YOU WANT IT TO BE A LONG-TERM GIG. It’s impossible to over-emphasize this issue when you are thinking about how to approach your financial life as a BigLaw attorney. What does this mean? The very long-term time horizons that go into the Gordon Gecko Math DO NOT APPLY TO YOU.
- To be very clear, BigLaw is not a pyramid scheme. But the business model is based on non-equity-partner attorneys doing work that is billed out to clients at a rate that is higher than the their all-in cost to the firm, with the excess funding profits-per-partner. Voluntary and involuntary attrition is baked in, such that the number of attorneys tends to shrink at more senior levels. Only a very small percentage of those that start out in BigLaw will make equity partner at a BigLaw–no matter how badly they want it. So, you know, if you diagram this out, it may bring a certain visualization to mind. If you are making your plans around making equity partner, especially when you are just starting out, you are being an idiot. Don’t be an idiot.
- Same song, different verse, and as discussed in Part 2, as long as you have massive student loans hanging over your head, you have no freedom. You don’t have the freedom to pursue the less lucrative non-BigLaw gig. You will be screwed five ways from Sunday if you find yourself being shown the door.
- Yet another verse. I was totally 100% ready to quit my BigLaw job a couple of years in. I found myself not liking what I was doing or the kind of pressure it involved. But I had paid off my loans. That gave me the freedom to work within my BigLaw job to obtain changes and concessions that could well have gotten me shown the door. I’ll post more about this in the future, but the freedom of FU money may paradoxically keep you from saying FU to your BigLaw firm. If that happens for you, any mathematical difference between paying off loans earlier and going Gordon Gecko is likely to be blown out of the water by a degree of magnitude. Don’t underestimate the value freedom provides. The same is actually true for financial independence more broadly, but winning the Great Student Loan War is the first step in that much longer path.
- Some people respond to all of these points by saying, well, take the money that you would have put toward paying your student loans early, and invest it in a safer investment than the rest of your money; that way, if you end up needing to pay your loans off, the money is available. Again, wrong. For many reasons.
- Paying off loans is risk-free, and your return on investment is equal to the amount of interest expense that is saved. (No, as a BigLaw attorney, you are not going to be able to deduct any of the interest on your student loans). Risk-free investments make, say, 2-2.5%, at best. It is conceivable that you will get that rate if you have excellent credit and credentials, but not a given, especially once tax leakage is factored in.
- It may be more likely that you could get a student loan rate that matches the rate of return on investments that are subject to a more moderate level of risk. Make no mistake, though. Investments that rank a “3” on Vanguard’s 1-5 scale can get hammered right along with everything else. This is not an apples-to-apples comparison when you’re dealing with comparatively short time horizons.
- Even if you compare to more aggressive investments, like equities, which is typically where this Gordon Gecko Math is performed, and even if you set aside the risk that you happen to need to pay your loans off in the middle of a market downturn, you’re going to have to grapple with capital gains taxes, likely at a 20% federal rate (perhaps moving up to 23.8% for some or all of the gain, if you’re more of a mid-level associate once you have to make your move, because of the Net Investment Income Tax–and this assumes the money has been invested for a year so the long-term rates apply), plus any applicable state taxes.
- Fundamentally, student loans are not the same as a mortgage, and when people start throwing around the Gordon Gecko Math, they tend to be using the kind of long-term investment approach that applies to the “Mortgage Payoff vs. Investing” question. That is its own, very difficult, question, but “Student Loan Payoff vs. Investing” is a very different set of facts. With a mortgage, unless you are going through a housing market downturn and you are underwater on your mortgage, in the absolute worst-case scenario, you can sell the house to pay off the mortgage. In some states, the mortgage may be non-recourse to you personally, though that’s an awful place to be in, and in the truly worst-case scenario, the recourse aspect of a mortgage can be discharged in bankruptcy. There is no such security blanket for student loans.
So, Dave Ramsey and Gordon Gecko are both out. How do you find the right balance between investing and paying down student loans aggressively?
- A pre-step: If you have accumulated any awful consumer debt–credit cards, high-interest car loans, whatever, and you don’ have any way to consolidate them into a lower interest rate loan, pay them off. And don’t be so ineffective with your money management in the future.
- Thou shalt max out your 401(k) contributions–probably traditional, rather than Roth, as I’ll discuss in a later post; your Backdoor Roth IRA contributions; and your HSA contribution. Giving up these tax-advantaged investment spaces is foolish. You’ve lost years and years of this space because of the time that you spent in school. So, use make these investments first.
- From there, I firmly believe it is critical to make a good faith plan to make as large of a dent in your student loans as possible–and hopefully eliminate them–by the end of that critical third year in BigLaw (yes, even if you took a year off to work a judicial clerkship, though you’re going to be at a disadvantage; those Prestige Points are costly). That is where the attrition really starts to bite, and it also a realistic goal. So figure out what a three-year amortization schedule looks like (it’s really three years and a couple of months, because of the first stub year), get that frugality gene exercised and turned on, and try to hit this goal.
- I’m likely to incur a lot of wrath here, so let me be clear. If you started with closer to $300k of loans than $200k of loans, this might be unachievable. If you have a kid in these first years, this might be unachievable. Given the ever-increasing cost of living in the BigLaw hubs, this might be unachievable. If you are a married, dual-income couple and you both have student loan burdens of this level, the unfortunate reality of the way the tax code treats married, dual-income spouses may make this more difficult (though I would argue it should be offset by economies of scale). But if you try to hit this goal, even if you don’t achieve it, you will be a lot better off than if you had set a goal of five or six years. BigLaw attrition does not care about your personal financial situation. It does not care about the fact that BigLaw is based in high-COL cities. It is just a fact of life. Plan accordingly.
- I’ll give more details about my path in a later post, but I sent my final loan repayment check to my creditors–which included my 401(k) administrator, as I utilized a 401(k) loan after taking my own step 1 advice–at the Year 2.5 mark. I was closer to $200k than $300k and I did not have a kid, but I was (and still am) in a married but single-income household, which has tax benefits but is a net drag on income compared to being unmarried and living alone, at least for most people.
- If you have money leftover after this, you can consider some other financial goals, like building a house downpayment (though I believe buying a house before you have a few years under your belt in BigLaw and have started to be fairly isolated from possible change in location). Or you could split the extra funds between extra loan repayments and investing in a taxable account (or in real estate, though I tend to think it’s likely that most young BigLaw attorneys do not have the time or skillset to be a landlord, so passive real estate investing is more likely). Or you could put it all toward student loans (which was the path I took), seeking to purchase your first stage of freedom that much more quickly. There is math and analysis that goes into all of these potential options, and I’ll probably explore them more in future posts, but if you’re finding yourself in this spot, you are doing incredibly well.
- A note about 529 plans and saving for kids’ college. Especially if you already have a kid at this stage, you may decide that taking advantage of the tax benefits of 529 plans justifies slowing down your student loan repayments, especially is you ascribe to the “hell or high water” theory of paying for your kid’s education. This is a deeply personal issue for people. In my view, it is a poor choice to put your family’s financial well-being at risk by diverting a significant amount of money to a 529 college savings plan while your student loans remain at a level where they would be difficult to service if you were to lose your BigLaw job. And I tend to believe that the adage that you can borrow for education but not for your own retirement is even more true here: your kid can borrow for an education, but you have already borrowed for yours. Put your own mask on before you help with your kids’. Also, while the tax benefits for 529 investing are meaningful–some states provide a deduction or credit, and the money grows tax-free if used for qualified educational expenses–only the state tax benefits and each year of tax-free growth are “use it or lose it” as a practical matter. That all being said, in an absolute worst-case scenario, if you have over-invested in a 529 and find yourself needing the funds to do an emergency payoff of your student loans, the money can be accessed, but with a pretty steep penalty. In my view, it’s not a risk people should normally take.
- When I say that only the state tax benefits and the time value of money is the only tax benefit lost from deferring 529 investments “as a practical matter,” this is what I’m talking about. Technically, contributions to 529 Plans count as “gifts.” Most people woefully misunderstand the tax rules that apply to gifts. Because of that, many people tend to treat the annual gift tax exemption, which is $30k for a married couple in 2019, as a cap on annual contributions (subject to a unique election available for 529 investments, pursuant to which you can super-fund a 529 in Year 1 and use the super-funding against your gift tax exemption for the next 5 years). But if you go over that cap, it’s not the case that there is an immediate tax to pay. Rather, the excess contribution counts against your estate tax exemption, in the event you end up in the rarefied group of people to whom that matters. Which you might!, if you end up sticking with BigLaw, making equity partner, and so forth. You’ll also have to file a gift tax return. But there is no actual immediate federal cash tax exposure (state laws differ). My view on estate tax issues is “that’s a rich man’s problem and, if I have an estate tax problem, my child will live nonetheless.” I firmly believe that planning around the possibility that the estate tax might matter to you is ridiculous, especially early in a career.
So, there you have it. The balanced approach to winning the Great Student Loan War.
Part 4–which will have a longer delay than the delay between Parts 1, 2, and 3–will explore how to proceed once you’ve won this war. The next steps to financial independence and, potentially early retirement. In the meantime, I’m expecting to write a few posts on my personal path to where I am now (and how I burned through my student loans in less than 3 years), some ideas around what it means to exercise the frugality gene in the way that you need to in order to win the war in 3 years or less, and, probably, other random thoughts.
In the meantime, what do you think of what I’ve put together so far? Feel free to leave comments below.