Mini-retirements (or sabbaticals) are becoming much more popular as people continue to challenge the idea of retirement. Essentially, a mini-retirement is an extended period of time away from work where you earn no income and spend your time in a way that is most meaningful to you - travel, spend more time with kids, volunteer, pursue other hobbies, etc. In a way, it enables you to test out how you will actually feel when you stop going to work one day. If you were saving money to one day move to Greece, wouldn’t you want to visit there first to make sure you like it?
A mini-retirement is a time for you to mentally reset and reevaluate how you want to spend your precious time going forward. Too often, people work jobs they don’t love and make unnecessary sacrifices so they can start pursuing what they truly want in “retirement”. What if you get to “retirement” and realize you actually don’t enjoy it? That’s why a mini-retirement is so important – it provides a preview as to whether or not you will actually enjoy what it is you are saving money for.
So how does a mini-retirement relate to student loans? For people with federal student loan balances that exceed their income, they should strongly consider how feasible taxable student loan forgiveness may be. Taxable student loan forgiveness (not tax-free public service loan forgiveness) occurs when you have been on an income-based repayment plan (PAYE, REPAYE or New IBR) for 20 years and you still have a student loan balance outstanding after that 20 years. However, that remaining student loan balance is taxable to you as income in the year it is forgiven, which is why this is often called the “student loan tax bomb”.
If your mini-retirement takes place in year 20, it means that your earned income essentially goes to $0 which dramatically decreases the amount of income tax you would owe from the student loan tax bomb. This mini-retirement would likely occur in your mid 40s which is also a great time to step away from work, mentally reset, and reflect upon how you want to spend your valuable time going forward.
If you properly plan, you can save money in a savings account or taxable investment account in the years leading up to your mini-retirement to pay for the expenses during this period.
Here are some numbers to illustrate the benefit
Let’s review an example to show how taking a mini-retirement can save you money on taxes.
- Roxie (also the name of my dog) just graduated Dental school with $285,000 of federal student loans.
- She consolidated her undergraduate and grad plus loans into one federal consolidation loan that has an average interest rate of 6.25%. Roxie elects Pay as You Earn (PAYE)
- Roxie expects to earn income of $160,000/year which increases 5% per year
- Roxie is married with 2 kids. Her spouse earns $100,000/year which we assume stays constant for simplicity sake
- They file taxes separately to exclude the spouse’s income from Roxie’s student loan repayment calculation
- Roxie maxes out her pre-tax 401(k) contributions each year
Here is the summary of payments if Roxie elects PAYE vs. the standard 10 year repayment.
How do payments differ for PAYE vs. standard 10 year repayment?
PAYE (over 20 years)
Standard Repayment (over 10 years)
Total payments made
Net present value of payments "today"
Remaining loan balance at end of repayment period
In this case, the remaining loan balance of $259,020 is subject to income tax (aka the student loan tax bomb).
If Roxie and her spouse were still working, they would owe about $104,000 of tax in year 20 as a result of the student loan balance being forgiven. This equates to roughly $39,000 in “today’s” dollars.
However, if Roxie and her spouse took a mini-retirement in year 20, then they would only owe roughly $58,000 of tax in year 20 as a result of the student loan balance being forgiven. This equates to roughly $22,000 in “today’s” dollars.
To recap – let’s compare what the total value of loan payments (in today’s dollars) would be under each scenario.
Total Value of Loan Payments:
Standard 10 year
Mini-retirement in year 20?
Total net present value of all payments/tax related to student loans
Whether you take a mini-retirement or not, the PAYE strategy results in significantly less dollars paid towards your student loans. However, if you also take a mini-retirement, it results in an additional $17,000 of estimated tax savings compared to if you didn’t take a mini-retirement.
This type of tax planning is a creative example for how you can plan for your money to match important life decisions. When you know there is a big tax bomb in the future, you can start planning for it early and even fulfill the important goal of taking a mini-retirement at the same time. Not only can mini-retirements be beneficial for your health, it can save you in taxes as well.
- Begin thinking about whether a mini-retirement is something that appeals to you. How would you like to spend your time? What are some things you want to accomplish?
- Start saving in taxable accounts to support living expenses for your mini-retirement. As with any other big life change, try to estimate how much your mini-retirement would cost you.
- Don’t always assume that paying off your student loans is the right thing to do. When your student loan balance exceeds your income, it is often worth a thorough review about whether loan forgiveness may make sense for you.
- MA resident
- 5% discount rate used for future cash flows
- Estimated tax due is a ballpark range and not the exact tax
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