How Student Loan Borrowers Can Use IDR Sensitive Investing to Earn More After Taxes

When asked for a simple answer on how to invest, I suggest 50% in Vanguard’s Total Stock Market Index Fund (VTSAX) and 50% in Vanguard’s Total International Index Fund (VTIAX). 

While that’s a perfectly reasonable allocation, it doesn’t fully account for the higher taxes that student loan borrowers pay on investments.

What do I mean by higher taxes? Specifically, student loan borrowers pursuing forgiveness lose 10% of their income to income-driven repayment (IDR) obligations. 

How is this loss that big of a deal, you ask? I’ll explain the concept of IDR sensitive investing and IDR sensitive portfolios, which will make you think a lot harder about tax efficiency in your own portfolio.

What tax rate do student loan borrowers pay on investment income?

There are four common types of investment income earned by individuals:

1. Taxable interest income, such as interest you earn on a high yield savings account.
2. Tax-free interest income, such as interest income you earn on a municipal money market like Vanguard Municipal Money Market Fund (VMSXX).
3. Nonqualified dividend income and short-term capital gains, which are taxed at ordinary rates.
4. Qualified dividend and capital gains income, which are taxed at “capital gains rates.”

The hit that student loan borrowers take that others don’t is the 10% IDR “student loan tax.”

Here’s how this plays out in practice.

Taxes for loan borrowers on dividend income

Suppose you’re a pharmacist in Georgia earning $100,000 a year.

Let’s also say you buy $1,000 of Coca-Cola stock, which yields 3%. This Coca-Cola stock generates qualified dividends, meaning it “qualifies” for lower taxes compared to other types of income.

With an annual income of $100,000, you’ll be in the 15% federal tax bracket for qualified dividend income. Additionally, living in Georgia means you’ll pay about 5% in state taxes.

If you’re pursuing pharmacist student loan forgiveness under the Saving on a Valuable Education (SAVE) plan, you’ll also lose 10% of your income to your IDR payment. Altogether, you lose 30% of your 3% dividend yield to taxes and loan payments.

So, instead of earning 3%, your effective yield drops down to 2.1%.

Consider a broader index like the S&P 500, which might yield only 1.3% because it’s dominated by a lot of growth companies like Facebook and Google.

If the same investor bought Vanguard’s 500 Index Fund, they’d lose about 0.4% each year in performance to taxes on dividends.

Related: Are Pharmacists Rich? Learn How They Can Be!

Splitting the broad market into growth and value

If you split the broad market into the half that’s growth stocks and the half that’s value stocks, you’ll notice the different yields that combine to make up the aggregate 1.3% dividend yield of the S&P 500.

For example, as of June 2024, the dividend yields of the Vanguard Growth (VUG) and Vanguard Value (VOOV) exchange-traded funds (ETFs) are:

• VUG: 0.47%
• VOOV: 2.19%

Instead of just holding the broad market index fund, a student loan borrower investor could allocate more heavily to growth stocks in their brokerage account and value stocks in their retirement account.

Why?

Because growth stocks incur less loss to taxes, while the higher yield of value stocks in retirement loses less to taxes.

If you held 60% VUG and 40% VOOV in your brokerage account and 40% VUG and 60% VOOV in your retirement account, assuming similar account sizes, you’d roughly approximate the Total Stock Market Index fund but in a more tax-sensitive way.

Now, let’s look at international stocks.

Taxes for loan borrowers on dividend income from international stocks

While the S&P 500 yields only about 1.3% as of June 2024, the Total International Index Fund at Vanguard yields roughly 3.3%. This means an investor could lose more of their dividend income to taxes on an international fund than on a domestic fund because they typically yield more.

But that’s not the only tax issue with this fund.

About 68% of the fund’s dividends are qualified, while 32% are non-qualified. That’s a stark contrast to the nearly 100% qualified dividend income of the S&P 500.

What that means is that within the Vanguard International Index Fund, 68% of the income benefits from lower tax rates and 32% is taxed at higher ordinary income tax rates.

Here’s how the formula works to determine how much you actually earn after taxes on a 3.3% dividend yield from the Total International Index Fund for a Georgia pharmacist in the 22% tax bracket:

3.3% x 0.68 x (1 – 0.22 – 0.05 – 0.1) + 3.3% x 0.32 x (1 – 0.15 – 0.05 – 0.1) = 2.23%.

This means the investor would lose about 1.1% in performance to taxes each year on the Total International Index Fund.

A more tax-aware approach would be to allocate more towards U.S. stocks in your brokerage account and more towards international stocks in your retirement account.

Putting together “IDR sensitive portfolios”

Let’s compare a 50/50 portfolio of VTSAX/VTIAX (U.S. and international total stock indexes) — we’ll call this Portfolio 1 — to a “tax-aware IDR sensitive portfolio,” which we’ll call Portfolio 2. 

In each scenario, let’s assume you have $10,000 in a brokerage account and $10,000 in a retirement account.

Note that for Portfolio 2, I’m using the three—and four-letter ETF names of funds instead of the five-letter mutual fund names. ETFs and mutual funds at Vanguard are essentially the same, except ETFs trade during the day and mutual funds trade once at the end of the day.

The allocation of Portfolio 1 is the same for both brokerage and retirement. It’s simply:

• 50% VTSAX
• 50% VTIAX

Portfolio 2 is more tax-aware and takes an IDR sensitive approach. As mentioned above, this means your brokerage leans more towards U.S. stocks, and your retirement account leans more towards international stocks.

Portfolio 2 for the brokerage account is:

• 35% VUG
• 25% VOOV
• 40% VXUS

Portfolio 2 for the retirement account is:

• 15% VUG
• 25% VOOV
• 60% VXUS

The overall allocation of Portfolio 1 and Portfolio 2 is the same: 50/50 U.S. and international.

However, the taxes you’d pay on Portfolio 2 are less.

The weighted average yield on the Portfolio 1 brokerage account is about 2.3%. The weighted average yield on the Portfolio 2 brokerage account is about 2.03%.

By taking the taxes on the difference in the yields on the two accounts, you’re saving about 0.10% to 0.15% on taxes each year, depending on your marginal rate.

Related: Ranked: Best Retirement Accounts for Physicians From Solo 401(k) to Brokerage Accounts

IDR sensitive investing is for bonds too

Student loan borrowers often deposit five or six figures of cash in high yield accounts, which they may plan to use to pay down loans or prepare for higher IDR payments.

But if you do that, you could lose 40% to 60% of the earnings on these accounts.

How?

Because of taxes and IDR payments. Let’s look at an example.

Suppose a California doctor earns a hefty income while pursuing Public Service Loan Forgiveness (PSLF). She uses a high yield savings account, which earns 5% interest.

She pays about 37% in federal and 10% in state taxes. Then, she loses 3.8% in Net Investment Income Tax (otherwise known as the Affordable Care Act, or ACA, tax) and 10% in IDR payments.

In total, she’s losing about 61% of her 5% interest income to taxes. Instead of earning 5%, she’s only netting 1.95%.

If she has any non-deductible physician mortgage loan interest, even if she locked in ultra-low rates in the early 2020s, she’d be better off paying that down instead of putting it into a high yield account and earning 5% interest.

Of course, many folks are earning 0.5% to 1% less than the maximum savings account yields because of inertia.

Student loan borrowers need to pay attention to whether they should use municipal money market funds and tax-free bond funds instead of taxable bonds and savings accounts. This strategy can help minimize the large loss of interest income due to regular taxes and IDR payments.

Related: Lowering Your AGI and Student Loan Payments with Municipal Bonds: A Win-Win Solution

Other Positive Tax Impacts of IDR Sensitive Portfolios

You might wonder, is it really worth making your portfolio more complicated just to save 0.1% in annual performance?

In isolation, maybe not. But when you think carefully about taxes on your entire investment income, the exercise makes a huge difference.

For example, if you realize paper losses (a process called tax-loss harvesting), you could generate five or six figures of offsetting losses to use against future gains, such as when you sell stocks to pay for your student loan forgiveness tax bomb one day.

Additionally, most investors simply use the default accounting method selected by their brokerage account.

If you sell stock, whether for a tax bomb in 20 years or a vacation home in five years, selecting the default accounting method could be far more costly due to being on an IDR plan.

For example, let’s say you have two $10,000 investments in the S&P. One was made 10 years ago and is now worth $20,000, and the other was made last week and is still worth $10,000.

If you use average cost and sell $10,000, you’d incur a gain of approximately $3,333.

As a student loan borrower, you’d likely lose about 30% to 40% of this gain to taxes, depending on your state’s income tax rate.

This means losing about 10% to 15% of your $10,000 sale to taxes.

Instead, you could choose the investment with the lowest gain and sell that instead for $0 extra tax.

Of course, these numbers would be magnified if the sale was for a six-figure down payment on a vacation home instead of a deliberately simple $10,000 stock sale.

Professional tax-aware investment management for professionals with student loans

SLP Wealth uses strategies like these to reduce clients’ tax burdens when investing. Asset location is a valuable part of an investing plan, and folks who ignore it will often lose a significant amount of investment performance to Uncle Sam without realizing it.

If you want to explore tax-aware, IDR sensitive investing and financial planning, check out our discounts for Student Loan Planner readers.

Legal note: SLP Wealth is a Registered Investment Advisor with headquarters in Durham, NC. Past performance is no guarantee of future results. This is a not a guarantee of future results or investment performance. All investing is subject to loss. This is not personalized investment advice.