calculations

IBR and PAYE Strategy in Community Property States

Michael Lux Blog 0 Comments

On their own, income-driven repayment plans like Income-Based Repayment (IBR) and Pay As You Earn (PAYE) can be complicated. When borrowers get married, the repayment strategy and calculations get even more complicated. The married borrowers who live in community property states face the most complication.

Couples who live in community property states can get lower monthly payments by signing up for IBR or PAYE and filing their taxes separately. However, the process can be confusing, and federal loan servicers do not make it easy.

Optimizing income-driven repayment in a community property state requires some tax considerations, math, and navigating red tape.

The Advantage of “Married Filing Separately”

One of the major downsides to the federal Income-Driven Repayment (IDR) plans is the calculation of income for married couples.

The purpose of income-driven repayment is to allow borrowers to make payments based upon what they can afford rather than what they owe. Borrowers can choose from one of several Income-Driven plans that charge 10, 15, or 20% of the borrower’s discretionary income.

Many couples are often upset to learn that discretionary income calculations are based upon a couples combined income. This means that marriage can result in significantly larger payments.

These higher payments can be avoided if the couple files their taxes as Married Filing Separately. Borrowers on Income-Based Repayment (IBR), Pay As You Earn (PAYE) and Income-Contingent Repayment (ICR) can exclude their spouse’s income from calculations by filing separately. The exception to this rule is the Revised Pay As You Earn (REPAYE) plan, which includes spousal income regardless of tax filing status.

While filing separately can mean lower student loan payments, it also means a larger tax bill. The tax rate for married filing separately is much larger than for couples that file jointly.

Couples will have to decide if the lower student loan payment justifies the higher tax payment each April.

Note for Couples who both have federal loans:
There isn’t a benefit to filing separately. If one spouse pays 10% of their discretionary income on a $50,000 salary while the other spouse pays 10% on a $40,000 salary, it is roughly the same as paying a total of 10% on a combined $90,000.

Student Loans in Community Property States

The United States has nine community property states. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska also has an optional community property system.

In community property states, assets acquired by the couple are presumed to be jointly owned. This policy affects student loan borrowers who try to file taxes separately to secure lower student loan payments. Rather than listing individual income on a married filing separately tax return, taxpayers have to report 1/2 the combined income of the couple on the tax return. This policy can have a significant impact on the potential savings from filing separately.

If the husband has federal student loans and an income of $50,000 per year, it might make sense to file separately from his wife, who earns $100,000 per year. In most states, by filing separately, the husband would have his student loan payments calculated based upon that $50,000 in income. In a community property state, the husband’s monthly student loan payment would be based upon an income of $75,000. In this example, the couple would be better off if they didn’t live in a community property state.

The good news for couples living in community property states is that there is one way around the jointly owned property issue…

Avoiding Using Spousal Income in Community Property States

In the Federal Registrar, the Department of Education has a special provision for couples in community property states who wish to exclude spousal income.

The relevant portion of the text states that:

The Department understands that married borrowers who file their Federal income tax returns separately from their spouses and who reside in community property states may be disadvantaged when determining IBR eligibility when compared to similarly situated married borrowers in non- community property states. However, §§ 682.215(e)(1)(B) and 685.221(e)(1)(i)(B) and § 685.209(a)(5)(i)(B) authorize the use of alternative documentation of a borrower’s income if the Secretary or the FFEL loan holder believes the borrower’s reported AGI does not reasonably reflect the borrower’s current income. Because the Department believes that it is inequitable to treat married borrowers who file their Federal income tax returns separately differently based on where they reside, we encourage FFEL loan holders to use alternative documentation of the borrower’s income under these circumstances. The Department will take the same approach with the loans it holds.

Source: Federal Registrar

In other words, there is a procedure for couples in community property states to exclude spousal income from IBR calculations.

Borrowers need to do the following:

  • File taxes separately,
  • Apply for income-driven repayment using alternative documentation of income, and;
  • Provide recent paychecks instead of a tax return.

Thus, to treat federal borrowers in community property states the same as borrowers in non-community property states, the Department of Education allows alternative documentation of income to get around the AGI calculation rules in community property states.

Final Thought on Filing Separately

Couples in community property states don’t have it easy, but they can file taxes separately to get a lower monthly payment on an Income-Driven Repayment plan.

However, just because something can be done doesn’t mean it should be done. Filing separately means a bigger tax bill. It also means a yearly hassle documenting income. The bigger tax bill and extra work doesn’t mean a smaller student loan balance; it just means lower monthly payments.

Borrowers working towards Public Service Loan Forgiveness may find that they come out ahead by going this route. Couples without a plan who want lower monthly payments may find that they end up spending more in the long run. In most cases, the debt will have to be paid in full and getting lower monthly payments will only delay repayment… not avoid it.