Dear Dr. Don,
I am 22 years old and graduating from college with no school loans. I hope to enter medical school in the coming months. My father wants me to contribute to a Roth individual retirement account even though I will need every penny I have for medical school. I now have $4,000 in a Roth IRA and he says that I should continue contributions just to maintain good financial habits.
I disagree. I think all of that money should go to medical school. Do you think even contributing $500 to my Roth IRA is better than using the money for medical school? Dad says either way, I'll be $200,000 in debt for medical school, so why not contribute?
-- Alaina Accrue
For you to contribute to a Roth IRA, you have to have taxable compensation, such as salary, in that tax year. If you don't have taxable compensation, then you don't have the ability to contribute to an IRA. Some parents fund accounts for their children. Funding limits are based on the lower of the child's taxable compensation or that tax year's IRA contribution limits.
For the 2014 tax year, for someone under 50, the contribution limit is $5,500.
It sounds like you're probably correct that medical school expenses will need to be funded. Do you want to put a little money aside in your 20s for retirement, or should it go toward medical school costs, limiting the loans needed to finance the education?
Let's assume a student loan rate of 7.21 percent, which is the 2014-2015 PLUS loan rate. The PLUS loan also has a disbursement fee of 4.288 percent through Sept. 30, 2014. Let's also assume that your investment return on the Roth IRA is the same, 7.21 percent. That's conservative versus last year's total return of the Standard & Poor's 500 index of more than 32 percent -- but a reasonable assumption for annual return on retirement investments over time.
You have the choice of using $1,000 to pay your medical school costs, or to invest $957.12 in the Roth IRA. The difference is explained by the disbursement fee. If you put your money into a Roth IRA, you pay the disbursement fee on the student loan money you take out to replace the Roth IRA contribution.
Let's compare the Roth IRA balance after four years of contributions versus the reduction in student loan balances. The reduction in loan balances wins by about $205. (I assume that you contribute to the Roth IRA at the beginning of the tax year and that the loan reduction is also for a full year.)
Loan costs versus Roth IRA balance
|Loan balance after four years||$4,774.89|
|Roth IRA balance after four years||$4,570.14|
There are other variables we didn't consider. When do loan payments start? Will you have to pay off all your loans or will some of the debt be forgiven? When will you start funding your retirement accounts?
I'd say if your dad wants to contribute to your Roth IRA, then let him contribute. If not, use your money for medical school and don't cash in the existing Roth IRA. That seems like a reasonable compromise to me.