Today’s mailbag questions come from a reader who has seen her required IBR payments unexpectedly reduced. Lower payments are definitely a good thing, but this reader is a little bit concerned about the reasoning behind the drop and the potential consequences…
First of all, thanks for all the information on your site– it is very helpful. I am a masters level social worker in North Dakota, and have two main questions. First one, I’ve consolidated- have been approved for public service loan forgiveness and IBR. I’m on set to make 120 qualifying payments then on to forgiveness (So far i’ve made 9). Do I need to be concerned with taxes? Will I owe taxes on my forgiven loan amount (it’s quite hefty). And secondly, my income hasn’t changed much, but my payment dropped about $100 a month. I reapplied on myfedloan website- so they have all my up to date tax information, but I was surprised when my monthly payment dropped despite my income. Will I be penalized for that? Were they using a higher income before, and was I overpaying?
Public Service Forgiveness and Taxes
Let’s start with the easy question: Student Loan Forgiveness and Taxes. This is a very straightforward subject, but one that often gets confused because people misunderstand the rule. If you qualify for Public Service Student Loan Forgiveness, and your loans are forgiven, it is not treated as taxable income. The year your taxes are forgiven will not result in a higher bill.
However, it is worth noting that the standard 25-year forgiveness on IBR, or the 20-year forgiveness on PAYE, do have tax consequences. The amount of debt forgiven is treated by the IRS as income, so if you have debt forgiven under these programs, you may have a huge tax bill in the future.
Because some forgiveness is taxed, while other forgiveness is not, it does get confusing. Just remember that public service forgiveness is the best kind of forgiveness because it is the quickest and there are no tax concerns.
Lower IBR Payments, but the same income
This is a more difficult question. The only way to truly resolve it would be to call your lender and ask about last year’s IBR calculation and how it compares to this year’s IBR calculation.
That being said, I can offer one possible explanation based upon my personal IBR experience. One year when I signed up for IBR I used my two most recent pay stubs. The following year, my lender just pulled my most recent tax return for purposes of calculating my payment. When they used my tax return, my IBR payment was lower. This was a surprise because my salary was exactly the same.
This one experience does not mean that IBR payments are always lower when based upon a tax return, but it does show how the two different methods of calculating payments can result in different numbers. When your lender has to evaluate your yearly income based upon your two most recent paychecks, they have to do a lot of estimating and they have limited information. The tax return shows the full picture.
Looking at it from this angle it makes sense that two different ways of documenting income could result in two different payments. A $100 drop is a pretty big drop, but if you had a ton of deductions on your taxes, it could potentially explain it.
As for your concern about overpaying, it is probably best not to dwell on it. There is no mechanism in place to get “extra” payments back, so the money paid is long gone.
Penalties for lower IBR Payments
Whether or not there is a “penalty” for a lower IBR payment depends entirely upon your perspective. For the reader working towards public service loan forgiveness, a lower payment just means more debt to be forgiven and less money to be spent each year. This is a definite win.
However, lower payments do have some consequences. If you leave public service, or leave the IBR program, paying less will mean that you will have more debt left to attack. In fact, it is possible that your monthly payments are less than the monthly interest on your loan. In that case the “penalty” for the lower IBR payments is a much larger balance.
Other than the additional interest over the life of the loan because of the lower payments, there is no “penalty” for reduced IBR payments.