I listen to Dave Ramsey from time to time, mostly when I’m doing things around the house and need some background noise. I don’t listen for any specific advice per se. Rather, I like hearing about the stories of the people who call in. A few weeks ago I was listening to his radio show on YouTube when a caller, and Dave’s subsequent advice, caught my attention. Now don’t get me wrong, I think Dave gives great advice at times, especially when it comes to debt. But some of his recommendations are not all that applicable to those with high incomes, such as physicians.
Someone called in for advice on her situation. She had just graduated from residency and was about to start her new position as an attending physician. I was folding laundry at the time, so I wasn’t paying too much attention to the fine details of the caller. I remember her future household income would be $400,000 per year, and that her student loans were $500,000. She was also calling from somewhere in Florida, although I don’t recall the exact city. I also don’t remember her age. She did mention that she had a non-working spouse, but did not say anything about having kids or other dependents. And other than her student loans, she had no other debts or obligations.
Her question for Dave was whether she should contribute to her retirement accounts while paying off her debt. Not surprisingly, Dave said no and that she should instead focus on paying of her debt as fast as possible. He did acknowledge that she would pay more in taxes, but that it was worth taking the tax hit in order to have more money left over to throw at her debt.
Good or Bad Advice From Dave?
When I heard Dave’s advice, I did a bit of a double take. While I’m not his biggest fan, I think that he does a good job of motivating people to get out of debt. But sometimes he can be a bit too rigid when it comes to the application of his Baby Steps.
But was this really bad advice? I decided to take a closer, mathematical look.
I wanted to compare the scenario in which the caller follows Dave’s advice (Caller A) to one where she contributes to her retirement accounts while paying off the debt (Caller B). In order to make this comparison, we’ll have to make some assumptions:
- Filing status: married filing jointly, non-working spouse
- No children or other dependents
- Takes the standard deduction for tax purposes
- Lives somewhere in Florida: I arbitrarily chose Miami
- Retirement savings:
- Caller A: $0 initially, then $29,500 ($18,500 401k plus $11,000 backdoor and spousal Roth’s) when loan paid in full
- Caller B: $29,500 from the start
- Annual expenses: $55,000
- The Bureau of Labor Statistics found that the average expenditure per consumer unit for 2016 was $57,311
- Consumer units include families, single persons living alone or sharing a household with others but who are financially independent, or two or more persons living together who share expenses
- Callers A and B put the entire remaining monthly net income toward loan repayment
I used the income tax calculator on SmartAsset to estimate taxes. Here’s a summary of each caller’s financial situation.
Let’s assume that both Caller A and Caller B were able to refinance the $500,000 to a fixed rate of 4% over a 10 year period. Given these terms, the monthly payment would be $5,062, the total amount paid would be $607,471, and the total interest paid would be $107,471.
Caller A would be able to pay $13,314 extra ($18,376 – $5,062), paying off the loan in 29 months and saving $82,452 in interest.
Caller B pays $11,397 extra ($16,459 – $5,062), paying the loan off in 33 months and saving $79,428 in total interest.
As mentioned previously, Caller A pays off her loan first then invests $29,500 per year ($2,458.33 a month) for retirement thereafter. Caller B invests the same amount but from the get-go. Assuming a total time horizon of 30 years (360 months) until retirement and a 5% annual rate of return, here’s what we would get:
- Pays off the loan over the course of 29 months, then invests for the remaining 331 months
- Have $1,721,392 at retirement
- Invests for 360 months (all 30 years)
- Have $2,012,629 at retirement
- Difference: +$291,237
Summary for Caller A and Caller B
Here’s a summary of what we have so far:
Income Tax Savings
By contributing the maximum to her 401k, Caller B saves about $6,486 per year in taxes. Since it takes Caller A over two years (29 months) to pay off her loan, Caller B realizes a total of about $12,972 (or $6,486 x 2 years) in tax savings.
Loan Interest Savings
By paying off her student loan quicker, Caller A saves $3,024 in total interest. This makes sense. The faster you pay off a debt, the less you pay in interest.
Not surprisingly, Caller B end ups with about $291,237 more in retirement than Caller A. By starting earlier, Caller B takes advantage of time and compounding.
Looking at these numbers, I would say that Caller B comes out ahead. Sure, Caller A gets rid of her student loans four months quicker and saves more in interest. But Caller B saves even more in taxes per year, and they also end up with a larger nest egg in retirement.
For Caller A, at what point does the money saved on interest approach the additional taxes they pay by not contributing to their retirement account? I ran some additional numbers, and it seems that she reaches this point at an annual salary of $200k. This, however, comes at the expense of a smaller retirement nest egg.
Not Bad Advice, Just Probably Not the Best
I think Dave is good at what he does. He motivates people to take control of their finances and provides them with a blueprint to do so. But sometimes he can be a bit too rigid with his advice. He applies his Baby Steps to everyone and recommends that each step should be completed in full before moving on to the next one. While this might be good advice for some, it may not be the most applicable to those with higher incomes like physicians. Here are some reasons why.
High Income = High Tax Rates
Most physicians will find themselves in the higher tax brackets, so the more you can shelter from taxes the better in my opinion. In the case of our caller, her income puts her in the 33% marginal tax bracket. So every dollar that she puts into her 401k means a tax savings of 33 cents.
Once Tax-Advantaged Space is Gone, It’s Gone Forever
You can’t go back in time and max out your 401k or your backdoor Roth IRA. Once that window for making contributions closes, it’s closed for good. All the more reason to make sure you contribute what you can to your tax-advantaged accounts.
Time Is Important
Time is one of the most important factors when it comes to saving and investing. Starting sooner rather than later allows you to take advantage of the power of compounding. The issue with physicians is that they’re usually a little late to the investing party. Four years of undergrad, four years of medical school, and three or more years of residency training is a lot of time. Also, most docs don’t have any significant amount of income until their mid thirties. Tack on the time it takes to pay back student loans and you’re pushing forty before you can really start building wealth.
Physicians Have Big Shovels
I can understand why Dave urged the caller to forego saving for retirement and focus on paying off her debt as quickly as possible. After all, $500k of student loan debt is a pretty big pile of crap. But a $400k per year salary is a pretty big shovel. It’s more than enough to get rid of that debt within five years while simultaneously saving for retirement.
The great thing about personal finance is that it’s personal. One size doesn’t fit all, and good advice for one person may not be the best for another. That why it’s always a good idea to look at your own situation, run some numbers, and then make a decision based on how things fit with your financial goals.
Readers, what do you think? Do you listen to Dave Ramsey? Have you used his Baby Steps? What advice would you the person who called his show? Let me know in the comments below!
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