Income Based Repayment and Forgiveness programs are a minefield of tax and financial complexity!
The foolishness that is the U.S. government's student loan policy gets crazier and crazier the more you study it and dig into the details.
Lets consider for a moment the Income Based Repayment program. Or shall we say programs, because there are at least four different versions, each with a different acronym and different rules. Even us financial professionals have trouble figuring all of this out!
In general, all the programs work in much the same way. If your income is low, but your indebtedness is high, you can use the programs to reduce your monthly payment so that it is no more than 10-15% of what the government considers your “discretionary” income. Discretionary income is your income, less an allowance for basic living expenses. If after a period of 20-25 years, you still have not repaid your loans, they will be forgiven, and the government eats any remaining balance. Oh yes – if you happen to work for a government or non-profit employer, your loan will be forgiven after only 10 years! Sound good so far? Well let’s think about this, because the best approach for borrowers is not always clear!
What borrowers often do not appreciate is that until the loan is forgiven, interest will continue to build on the loan balance. Lets say you owe $60,000 and the interest rate is 6%. Further, lets assume that the borrower makes very little money, and does not have to make any payments for 20 years. By the time the 20 year repayment period is over, the amount owed will grow to $192,000!!!
“But so what?” you may think, “the balance is being forgiven anyway, I don’t care how big it gets”. Oh but the IRS cares. That entire $192,000 loan balance will be taxable income to you in the year it is forgiven. Your tax bill on that forgiven loan could be as much as the original loan balance – and the IRS is not nearly so flexible as the Education Department when it comes to repayment! I should note here that Public Service Loan Forgiveness is not taxable, making it even more attractive to work in the government or non-profit sectors if you have a lot of debt!
Now lets consider another trap. Let’s say Johnny studies theater and is a starving artist, earning minimum wage while he waits for his big break. He can’t afford payments on his student loans, and is using the income based repayment option, which cuts his payment by $400/month. He falls in love with Julie, who has a good paying job making $90,000 per year and they get married. Johnny realizes that if they file a joint tax return, he will have to now start paying the full amount of his student loan debt (which has been growing rapidly since he has not been paying all the interest). He decides that he and Julie will file separate tax returns, which (under the rules of 3 of the 4 income based repayment plans) will permit him to continue with his lower payments.
But is this a good plan? Not necessarily. Julie makes $90,000 per year so with 1 exemption and a standard deduction I estimate she pays about $15,639 per year in federal tax. Let’s assume that Johnny didn’t make anything this year (no gigs) so he pays nothing on his return. If they had filed a joint return, with Julie's income and 2 exemptions and 2 standard deductions, their tax bill would have only been about $9239. The tax savings from filing a joint return would have paid for all of the additional debt payments, and would have allowed Johnny to start to pay down his debt, instead of letting it grow into a mountain of “forgiven” future taxable income! So be wary of the siren song of “debt forgiveness.” It is a hugely complicated program with many traps and pitfalls awaiting the uninformed.
So are you now totally confused? You are not alone. I can’t even imagine that the average 23 year old without extensive training in finance and the tax code will ever be able to make a sound decision about loan Fi
Financial Pathways Financial Coaching program can help figure out the best way to deal with your student loan debt. Unlike many financial advisory program, we work for a simple and affordable hourly fee, and we don’t sell any financial products. Give us a call today to schedule a coaching session, in person in one of our New Jersey financial planning offices, or online.
Financial Pathways Coaching LLC does not provide investment advice. Investment advice may be provided through Financial Pathway Advisors, LLC, a Registered Investment Advisor in the state of New Jersey. Tax projections are estimates based on hypothetical calculations, and are not intended to be tax advice.