Your discretionary income is the most important number when calculating student loan payments on income-driven repayment (IDR) plans.
Fortunately, discretionary income calculations are easy. Better yet, the Department of Education now has a great tool for estimating monthly payments on the various federal repayment plans.
This article will cover the basics of discretionary income calculations, explain why these calculations can be unfair, and I’ll share some of my favorite “hacks” to lower your monthly payments.
Why does my discretionary income matter for student loan payments?
If you have federal student loans, some of the best repayment plans are income-driven repayment plans such as Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE). The reason these plans are the best is that your student loan payment is based upon what you can afford rather than how much you owe. For many borrowers, this can result in a significant reduction in minimum monthly payments.
Under IBR, the Department of Education expects you to pay 15% of your discretionary income towards your student loans. The PAYE and REPAYE plans reduce that number to 10%. Details like marital status and when you first borrowed a student loan will impact which Income-Driven Repayment Plan is best.
But what exactly is discretionary income for student loans?
Before you have to pay anything under IBR, PAYE, or REPAYE, the government lets you keep 100% of your salary up to a certain point. That number is set at 150% of the poverty level. According to the Department of Education, this is the portion of your income that is non-discretionary. The federal poverty level changes each year and is based upon your family size. For 2020-2021, the numbers look like this:
|Household Size||150% of Poverty Level|
When calculating student loan payments, your discretionary income is every dollar (pre-tax) that you make above the numbers listed on the table. Suppose your housed size is three, and you make $44,580 per year. In this example, your discretionary income would be $12,000 per year. We get this number by subtracting the $32,580 for a family of three from the $44,580 yearly salary.
Calculating your payments in 2020 and 2021
Once you determine your discretionary income, divide that number by 12. The new number is your monthly discretionary income. In our example, it would be $1,000. That means that if you were on IBR, your monthly payment would be $150, and if you were on PAYE or REPAYE, your monthly payment would be $100.
Note: the exact calculation will vary depending on how you verify your income with your lender. Some people use their two most recent pay stubs while others use last year’s taxes. If you use your most recent tax form, it will use your Adjusted Gross Income or AGI.
One of the most useful tools for calculating monthly payments is the Federal Loan Simulator. This tool allows you to use your actual loan information in generating the estimated monthly payments. It also helps with student loan forgiveness planning.
Why is discretionary income an unfair calculation?
How much you can truly afford to pay depends upon a whole lot more than just the size of your family. Unfortunately, these factors are not considered. If you have medical bills, owe child support, or have other private student loans, your discretionary income does not change.
The 48 contiguous states are all treated the same. Whether you live in rural Kansas or San Fransisco, the numbers do not change. Applying the exact same standard without adjusting for the cost of living means some borrowers will have a discretionary income that exaggerates how much they can reasonably afford.
Sheltering income from discretionary income calculations
However, as noted earlier, for most people, income is based upon their AGI.
Borrowers can keep this fact in mind when doing their tax planning.
My favorite strategy is to put money in tax-advantaged retirement accounts like a 401(k) or traditional IRA. Putting money in an eligible retirement account will result in a lower AGI.
Putting some money in a traditional IRA will do the following:
- Lower monthly student loan payments,
- Lower the amount spent on taxes, and;
- Build retirement savings.
The approach is especially powerful for borrowers working towards student loan forgiveness because it means more debt will be forgiven in the end.
Unfortunately, not all borrowers are in a position to set aside extra money for retirement. The good news is that there are other ways to lower your AGI. Borrowers should seek out tax breaks that are considered to be above-the-line. I’ll skip the details on AGI calculations, and just point out that any above-the-line deduction will reduce the AGI.