Today’s post comes from a question sometimes asked by savvy law students: Should I borrow extra money in law school to fund a Roth IRA? My answer is unequivocally yes. In fact, I did so myself to fund a Roth IRA in my 1L and 2L years. Given that it’s usually a dumb idea to invest on margin, this may seem counterintuitive but ultimately I decided the benefits far outweighed the risks.
To be eligible to contribute to a Roth IRA, you must meet the earned income requirement. For the income to be “earned”, it must be taxable compensation (not taxable income from investments). As an example, if you have $2,000 in earned income, your maximum Roth IRA contribution for the calendar year is $2,000.
The concept of earned income is important, because often law students do not earn income while in law school. If you didn’t earn any income, funding a Roth IRA is not available to you.
Some students will be eligible as follows: (1) a 1L who worked during the Spring and Summer before law school started; (2) a 2L year who worked during the summer; and (3) a 3L who begins employment after the summer bar exam. This strategy is for 1L and 2L year. I assume the 3L students who begins working after the bar exam can fund a Roth IRA contribution from earnings.
How to fund a Roth IRA
Assuming you meet the earned income test, you are eligible to contribute up to $5,500 to a Roth IRA. During your 1L and 2L years, because you spent substantial time in law school and were presumably not working, I’m assuming that your income for those years is not much. It’s likely that you used your earned income to cover living expenses and don’t have it to contribute to a Roth IRA. It goes without saying that if you don’t need to borrow the extra money to fund a Roth IRA, you shouldn’t borrow that money. For now though, it’s only important that you earned the income to meet the eligibility test (i.e. because money is fungible, the source of funds for your Roth IRA contribution is not important).
If you don’t have the money to fund a Roth IRA, where should you get the funds? From your law school loans of course. Once your law school loans are disbursed, you can use $5,500 from the disbursement to fund your Roth IRA. The contribution is valid because you have $5,500 of earned income during the calendar year. There is nothing more for you to do. If this causes you to borrow more money under your student loans than you otherwise would, not a problem. That’s exactly what I did.
The benefits of funding while in law school
Roth IRA contributions are after-tax. You pay income taxes on the income in the year it’s earned. Your Roth IRA account grows tax free. Withdrawals of Roth IRA earnings after age 59.5 are tax and penalty-free. By paying taxes now, you gain tax-free growth and eventual tax-free withdrawals.
Because your income is low during 1L and 2L year, there shouldn’t be much taxes to pay on the $5,500 in earned income. The 15% tax bracket covers adjusted gross income between $9,226 and $37,450. Even a summer associate in Biglaw will not have an AGI above $37,450. So, I think it’s safe to assume that most law students will pay 15% (or less) on the $5,500 of earned income used for the Roth IRA contribution.
But therein lies the benefit of this strategy: you were already paying taxes on the earned income, which presumably went toward living expenses. But, you paid zero income taxes on the amount borrowed from the lenders under your student loans. So, no income taxes on the money received, no income taxes during growth and no income taxes upon withdrawal? It’s a triple-tax advantaged situation. The holy grail.
Cost of front-loading Roth IRA investment
But wait, there is a cost to funding your Roth IRA from extra student loans. You incur more student loan debt to fund the Roth IRA. That means the extra $5,500 borrowed may be incurring interest around 6.8% yearly. Does that negate the benefit of making the Roth IRA investment in the first place?
Not really. You’re taking advantage of a limited window (Roth IRAs can only be funded each calendar year) to front-load your investment, which you will pay back over time. You’re paying a premium to do so.
Let’s break that down:
Limited Roth IRA Window. Contributions to a Roth IRA can only occur during the calendar year. If you don’t contribute, you lose that tax-advantaged space forever. Based on our assumptions above, your options are either to make the contribution using borrowed money or not make the contribution at all.
Front-Loading Roth IRA Investment. Because you do not have the cash on hand to fund the Roth IRA, you borrow money at 6.8% interest today to fund the investment. You pay the $5,500 over time. The student loan lenders charge interest on the borrowed money until it’s repaid.
Premium. The premium you’re paying for the ability to front load your investment is the interest rate on your student loan.
Running the numbers
Roth IRA Investment. If you make the Roth IRA investment, at age 59.5 you will have $41,867.40 in a tax free account, assuming a growth rate of 7%. You will pay $9,252.66 to pay off the $5,500 you borrowed, assuming the borrowed money incurs interest of 6.8% for the three years you are in law school and then you pay it off over 10 years, incurring 6.8% interest the entire time.
Non-Roth IRA Investment. If you skip making the Roth IRA investment but instead start investing the money you would have used to pay off the extra student loan, you will end up with $40,385.26 in a taxable account. This assumes that immediately after your third year you begin setting aside monthly payments equal to $9,252.66 over 10 years to a taxable account. In this taxable account you get the same 7% return during the 10 years of contributions. After you’ve contributed $9,252.66 to the taxable account you stop contributing but continue to enjoy a 7% return until age 59.5.
The first difference is the obvious $1,500 gap in the account balance. This is the benefit of getting a head start in the market investing your 1L year.
The second difference is the funds in your Roth IRA account are not taxable. Obviously the taxable account is, well, taxable. Assuming capital gains taxes of 15%, the alternative investment is worth $35,630.37 ($40,285.26 minus $9,252.66 (cost basis) X 15% = $35,630.37). Don’t forget that you’ll also be paying taxes on dividends and capital gains along the way in your taxable account, which will further reduce your ultimate earnings.
I think it’s safe to say that borrowing the money for the Roth IRA is the right mathematical move. Whether you’re comfortable with the risk is a different decision.
Why the math works in your favor
The reason why the math works in your favor is because your Roth IRA will grow and compound for many more years than the time it will take you to pay off your student loans. Assuming a 30-year-old law student, the Roth IRA will grow for at least another 29.5 years. Meanwhile, you will probably pay off your law school loans in 10 years or less. The less interest you pay, the better the math works for you. If you refinance your loans post-graduation, even better.
This means the math works whether you get a 3% return in the market or a 10% return. The time value of compounding will win in the end and the tax-free growth in the Roth IRA will be greater than the taxable growth you could achieve otherwise.
What if things go wrong?
If you’re worried that you might lose your job or otherwise not be able to pay back your student loans, you might be concerned by the fact that you’ll now have an additional $11,000 in student loan debt (2 years X $5,500 each year). The $11,000 in the Roth IRA is tied up in a retirement account, right? Well, more good news. Roth IRA contributions are always available to be withdrawn tax-free and penalty-free at any time. So if you run into any problems, withdraw the $11,000 from the Roth IRA and immediately apply it to the student loan. You’ll lose money on the interest paid on the student loan, but it shouldn’t be a disaster. Having this as a backup plan makes the investment even more of a no-brainer.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money. He's also exploring real estate crowdfunding platforms like Fundrise which are open to both accredited and non-accredited investors.