Drowning in student loan debt isn’t fun, and that’s especially true when you realize that there are so few ways to dig yourself in. You can pay off your loans the hard way, spreading a significant portion of your income over ten years with a standard repayment plan. You may also go for a loan forgiveness program like the Public Service Loan Forgiveness (PSLF) and be required to fill a handful of specific public service positions that may not be ideal then may be cancel your loans after ten years. While the PSLF is a good idea in theory, it’s hard to get excited about only a small percentage of applicants are actually approved.
But what about income-driven repayment plans? These plans, which include Income Based Reimbursement (ICR), Income Based Reimbursement (IBR), Pay As You Earn (PAYE) and Pay As You Go Revised (RePAYE) , allow you to pay a percentage of your discretionary income for 20 to 25 years before forgive your remaining loan balances. Beyond the lower payment you can enjoy for most of your adult working life if you qualify, you don’t have to work in a specific job or in the public interest with these plans.
The main problem with income-driven repayment plans is the potential for serious tax consequences down the road. This is because unlike the PSLF, income-based repayment plans require you to pay income taxes on the amount of debt forgiven.
How much will the “tax bomb” cost you?
The current version of yourself may think that paying a small percentage of your discretionary income for the next 20 to 25 years sounds wonderful, but what about your future self? By the time the actual loan forgiveness takes place with these programs, you might regret your choice in a major way. This is because during the year your debt is canceled, the canceled debt is treated as taxable income (under current tax legislation).
Unfortunately, it’s hard to know how much you might have to fork out. How much you owe in taxes in the year your debt is canceled will depend on a variety of factors, including how much you earned in that year and your current tax rate.
Depending on your situation, you may owe more than you think. According to Institute for Access to and Success in College (TICAS), a small business owner with $ 50,000 in student debt who is married and has two small children may have to pay an additional $ 13,050 in income tax in the year their debt is canceled. In another example, a divorced social worker with two children and $ 55,000 in debt could pay up to $ 19,000 in additional federal taxes in the year his loans are canceled.
There are several reasons why this could be considered unfair. First, have your student loans forgiven is not exactly a godsend. You don’t actually have your hands on the money handed over, so that means having to dip into savings and investments in order to pay a bloated tax bill.
Also, keep in mind that income-driven plans don’t necessarily save you money on your student loans to begin with – they just spread out smaller payments over a whopping 20 to 25 years.
Plus, if your payments are unusually low, that also means your income is low – and you probably haven’t had much opportunity to save over the years of repayment to have the extra cash to cover the cost. tax invoice.
In several examples that TICAS shares in its recent study, income-based repayment plans cost much more money to long-term student debtors. One of them is the married small business owner with two children. As TICA says, this mythical person with $ 50,000 in student loan the debt would be:
- Pay off the entire loan balance plus $ 21,650 interest with IBR or REPAYE, only to owe $ 13,050 in additional federal income tax when their loans are canceled
- Pay off the entire loan balance plus $ 55,400 interest with REFUND, only owing an additional $ 3,700 in federal taxes when their loans are canceled
In contrast, with a standard ten-year repayment plan, they would likely pay the entire loan balance plus $ 19,050 in interest over 120 months, leaving them debt-free at least ten years earlier. The standard repayment would also save them from having to deal with the student loan forgiveness tax bomb. Of course, their monthly payments would obviously be higher along the way, which may not be sustainable for everyone.
Insolvency could help
If you have significant student loan debt and are worried about having to pay a huge tax bill later in life, being insolvent may help you avoid it.
Insolvency is a tax term used to describe situations where your debt (the amount of money you owe) exceeds your assets. If you are able to prove that you are insolvent when your student loans are canceled, you may be avoiding the tax bomb altogether.
Here’s a good example of what insolvency might look like given the assets and liabilities of an average person:
- Current account: $ 3,200
- Balance 401 (k): $ 27,000
- Automotive: $ 16,000
- Personal property: $ 7,000
- Total assets: $ 53,200
- Federal student debt: $ 60,000
- Private student loans: $ 47,000
- Credit card debt: $ 8,700
- Total liabilities: $ 115,700
In this case, the debtor is considered fully insolvent with total assets of $ 53,200, total liabilities of $ 115,700 and an “insolvency number” of $ 62,500 (liabilities less active). They are totally insolvent in this case because their insolvency count is higher than their federal student debt amount, which is $ 60,000.
Also, keep in mind that you may be eligible for partial insolvency if you have significant debt and few assets, but are not fully insolvent. In this case, you would only pay income tax on the part of your debt that exceeds your assets. This means that you won’t completely escape the tax consequences of forgiveness, but it can certainly help ease your burden and make it more bearable.
Time can be on your side
Ultimately, this is all hypothetical. If you plan to pay off your loans with an income-based repayment plan over the next 20-25 years, you can only speculate on what your financial situation will be like when your tax bomb hits. You might be doing so well financially that you might not care about the tax bill, or you might be entirely insolvent and never have to pay a dime. It’s hard to plan for something this far away when you don’t have a clue of where you’ll be at this point in your life.
Remember, too, that a few decades is a long time. If you believe the Democratic presidential candidates, then full student loan cancellation could be a reality well before your income-based repayment plan ends.
Some states, including California, have even passed legislation to address this tax penalty at the state level. It is possible that over the next several decades more laws will be passed by states and even the federal government that could potentially reduce the tax burden on people who have made a loyal effort to repay their loans.
Should you be worried about the student loan forgiveness tax bomb? It’s okay to keep this potential problem in mind, but I don’t think you should avoid income-driven repayment plans based on tax implications that may or may not happen in 20-25 years. Income-driven repayment plans can make paying off your student loans considerably more affordable for decades to come, which could mean a much higher quality of life for the foreseeable future.
I suggest doing what’s best for your finances and your life while you are young. If the tax bomb seems inevitable in a few decades, then you can deal with it. The worst thing you can do is avoid paying off a student loan altogether.