Grad School Finance #3.1: Coast FIRE, Apply, then Roth Conversions

Worried about how to afford graduate school? Today’s post is an extension of a prior post in the Grad School Finance series, which is all about strategies you can use to mitigate (but never eliminate) the steep financial opportunity costs of going to graduate school for a Ph.D.

Recap: The Original Coast FIRE, then Apply Plan

In Grad School Finance #3, I lay out the Coast FIRE, Then Apply plan for minimizing the indirect costs of attending graduate school. Basically, most of us attend graduate school after completing our Baccalaureate, spending our early to late 20s taking out loans or earning $25k stipends in an expensive place. Likely few of us save or invest much money during this time, meaning we likely miss out on the most important investment years of your life. Due to the power of compounding, money you invest in your 20s will often be worth double at retirement compared to what you invest in your 30s, and 4x what you invest in your 40s. This means that going to graduate school straight out of undergrad is a very costly decision.

The Coast FIRE, then Apply plan seeks to mitigate these opportunity costs of grad school attendance by recommending you consider delaying applying for graduate school until you’ve reached your Coast FIRE number (an amount of savings which, when allowed to compound until retirement, will allow you to have a minimally-acceptable retirement at a safe withdrawal rate of your choosing). This way, whatever the outcome of your further academic undertakings, you can be confident that you won’t be destitute in retirement.

Addendum: Roth Conversions!

The original plan is, in my famously humble opinion, the best one I’ve heard on how to mitigate the high indirect costs of graduate school attendance. Here, however, I’ll add an additional wrinkle to increase its impact: Performing Roth conversions on your pre-tax retirement contributions while in graduate school.

Refresher the First: Pre-Tax and Roth Contributions

Here’s how this works: Normally, in your 403(b) (or 401(k), or traditional IRA), you contribute pre-tax dollars, meaning that your tax obligations are deferred until a later date so that the full pre-tax amount can compound over time. When you withdraw these funds in retirement, you pay taxes on withdrawals as ordinary income.

There are also Roth 401(k) and 403(b) contributions (meaning you pay tax upfront but then all subsequent growth and withdrawals are tax-free if you follow the plan rules), but if you’re following this plan I’m going to recommend you not take advantage of these options. The reason is that your tax rate will likely be much lower while you’re in graduate school, and you’ll have the option to pay your marginal tax rate on these funds during this time window, with the result that you minimize your lifetime tax burden on your retirement contributions.

Refresher the Second: Tax Brackets and the Marginal Dollar

How much can this reduce your eventual tax bill to help you afford graduate school? Quite a lot.

Progressive Taxation

To see that, recall that the US follows a progressive taxation system, such that your first $X of income are untaxed, your next $Y income is taxed at a low rate, then each marginal dollar after that is taxed at higher rates in a series of steps.

However, these steps are pretty uneven. Assuming you aren’t itemizing your taxes and take the single filer standard deduction of $12,950 as of this writing, you can earn that much without paying any taxes. Beyond that point as a single filer, your next $11,000 are taxed at 10%, and the next $33,725 are taxed at 12%. After that, the next tax bracket is 22%, which means that the first $57,675 (= $12,950 [standard deduction] + $11,000 [10%] + $33,725 [12%]) of income you earn as a single filer are taxed at much lower rates than any additional dollars you earn. (Incidentally, this is an underappreciated benefit of pre-tax contributions generally — your retirement plan contributions are withdrawn from your highest tax bracket, but are taxed in retirement from the bottom bracket up.)

An Example

To further belabor the point, let’s consider three highly simplified scenarios:

  1. Traditional contributions: You contribute $100k pre-tax to a 403(b), let it compound at 7% annually over 30 years, then pay 22% in taxes on withdrawals.
  2. Roth contributions: You take $100k pre-tax income, pay 22% in taxes on it up front (leaving $78k), and contribute it to your 403(b) as Roth contributions, then let it compound at 7% annually over 30 years, then withdraw the money tax-free.
  3. Grad school Roth conversions: You contribute $100k pre-tax to a 403(b), let it compound at 7% for 5 years, perform a Roth conversion at a 10% taxation rate, and let it compound at 7% for 25 more years.

To be absolutely clear, I’m well aware that you can’t contribute $100k to your 403(b) in a given year and that you’re unlikely to withdraw it all at once when you retire. I promise, the basic conclusions are the same if I had it play out in a more realistic scenario. I’m just trying to keep things simple here.

If you’re following the Coast FIRE, then Apply plan, you likely earned more than this before graduate school, meaning that without pre-tax retirement contributions the last dollar you earned each year would have been taxed at at least 22%. Hopefully, you’ll also earn more than this as a PhD graduate, meaning any marginal dollars will also be taxed at 22%.

However, it’s pretty unlikely that you’re earning more than that in graduate school. Hell, I may be a dinosaur, but my NIH stipend in graduate school was less than $21,000 per year. Currently, the same training program stipend is $27,144. Even if your stipend is much higher, chances are your marginal dollar is taxed at 12%. This is likely the lowest tax rate you’ll ever be subject to absent early retirement — you should take advantage of it!

How much money do you end up with after 30 years?

  1. Traditional contributions: $593,755.89
  2. Roth contributions: $593,755.89
  3. Roth conversions: $685,102.95

That’s $91,347 more at retirement compared to either of the standard approaches. As you can see from the fact that the traditional and Roth routes leave you with the same amount of money at the end, traditional vs. Roth doesn’t matter at all if your money will be taxed at the same rate in either time window (when you earn it vs. when you retire). This is because this is an exercise in multiplication, and the order you put numbers in when multiplying doesn’t matter — i.e., 7 x 6 = 6 x 7 = 42, the meaning of life, the universe, and everything, no matter how you get there. Similarly, paying 22% taxes upfront or at the end doesn’t matter — you end up with the same amount.

However, by paying 10% in graduate school rather than 22% before or after, you can save almost as much as you contributed in the first place. That’s a huge difference to help you afford graduate school!

How Roth Conversions Work

Let’s assume you’re convinced this is the way to go. How do you go about it?

After you leave an employer, a number of restrictions on where you can put that money are relaxed. Often, the best move (regardless of whether you’re following this plan) is to roll your old 401(k) or 403(b) into a traditional IRA — you’ll have more and probably better investment options and be in full control of your finances.

Once you’ve done that, performing a Roth conversion is easy. All you have to do is the following:

  1. Open a Roth IRA.
  2. Transfer some funds from your traditional IRA into your Roth IRA.
  3. Pay income taxes on the money you transfer in each tax year at the end of the tax year.

That’s pretty much it. If you do this, you should read more just to make sure you’re comfortable with the full process and implications. You can do that here. My job is simply to point out to you that graduate school is the perfect time to do this. (Incidentally, the other great times would be if you had a short period of unemployment between jobs that moved you into a lower tax bracket, or if you take a full-year sabbatical for reduced salary. Maybe I’ll write another post about these scenarios in the future.)

The remainder of this post summarizes how I now recommend you follow the Coast FIRE, Then Apply plan.

What to Do Before You Apply to Grad School

Please note that the list below is everything you would ideally do before graduate school to set yourself up for maximum financial success. If you can’t do all of this (and most can’t), work your way down the list until you can’t save/invest anymore. If you get through step 3, you’ll be far better off than most people your age.

  1. After you’ve finished your undergraduate degree, get the best paying job you can.
  2. Contribute to your 401(k) or equivalent up to the point of your maximum employer match (if applicable) each year.
  3. Max an out a traditional (pre-tax) IRA (annual limit currently $7,000) every year.
  4. Max out your 401(k) (annual limit currently $23,000) with pre-tax contributions every year you’re able. Note that employer contributions and any mandatory contributions you make do not count toward this limit (though there is a maximum contributions total for you and your employer, you’re unlikely to hit it).
  5. If you have additional remaining funds, set some aside in a very safe vehicle such as high-yield savings accounts or CDs. Use these funds to pay your Roth conversion taxes in grad school. Save about 10% of the funds you saved in steps 2-4 here.
  6. If you have even more additional funds, add $6,500 x the expected number of years you’ll be in grad school or postdoc to that same safe account, to pre-fund your future Roth IRA contributions.
  7. If you have even more money to spare (and this is getting laughable, I know), you can put it into a taxable brokerage account if you want. Or, you know, you could just enjoy your life.
  8. Apply to graduate school. Look deep into your soul and decide if you’re still excited to do this. If you are, matriculate in the best program you can get into.

What to Do While in Graduate School

  1. Work your butt off while not forgetting to have fun, make friends, and take care of your mental health.
  2. Roll your old employer 401(k) into your traditional IRA account.
  3. Each year, calculate your adjusted gross income (AGI). Unless you have unusually complicated taxes for a grad student, you do this by taking your total graduate stipend and other income and subtracting the standard deduction for that year.
  4. Then look up what tax bracket you are in for your top dollar, and the gap between your top dollar at the high end of the 12% tax bracket (if it still exists). Call that difference $X.
  5. Perform a Roth conversion on $X by transferring it from your traditional IRA into your Roth IRA (which you’ll need to open if you don’t have one, but your brokerage will walk you through it).
  6. Pay taxes on the Roth conversion from your saved funds if you have them or from your stipend if you don’t. Make sure you don’t convert more funds than you can afford to pay taxes on.
  7. Move on with your life, confident that you’re putting yourself in an excellent financial position for the future, academic job market be damned!

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