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:
The benefit of filing separately is greatly reduced. As couples have more children, the benefit of filing separately increases.
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
If your most recent tax return does not accurately reflect your income, borrowers are allowed to provide alternative documentation of income. Typically, the alternative documentation is a recent paystub. However, borrowers may also provide their servicer a letter in more complicated situations.
The significance for borrowers in a community property state is that it is possible to avoid using 1/2 your combined income as the starting point for payment calculations.
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.
Hi and thank you for this article. We now live (moved from UK) in a community property state (AZ), and we are finalising our 2021 taxes just now. I understand from your article that I can hopefully make the loan servicers understand my actual income, not what my tax return will reflect. (my spouse’s income has inflated my income significantly, and I will not be able to pay the IBR payments).
In any case, will they accept my pay stubs if I am paid in UK pounds? I work for my UK employer remotely.
That is a really interesting question. I don’t see why they shouldn’t, but I’ve never seen this approach used before. If it doesn’t work, you may have to come up with some alternative methodology to document your income, but your servicer should be able to help.
Thank you very much. I will attempt to submit my UK pay stubs along with a letter from my company documenting the foreign exchange rate of annual salary. Fingers crossed it will work.
Hello. You were kind enough to answer a question of mine several weeks ago. I have one more question before I consolidate my loans.
I have two consolidated FFELP loans from 2006 which together are approximately $25,000. I have one unsubsidized and one subsidized loan from 2006 which together are approximately $22,000. I have two subsidized and two unsubsidized loans from 2007 which all together are approximately $63,000. Will I be eligible for PAYE, IBR or PAYE after I consolidate these federal loans since some originated prior to 2007 or will my new loan date be the date of consolidation. I am preparing to consolidate and want to utilize a plan where I can be married and file taxes separately. I appreciate enormously your answers. Thank you.
Based on your description, it sounds like you will not be eligible for PAYE whether you consolidate or not. Likewise, you won’t be eligible for “IBR for New Borrowers” either.
Consolidation shouldn’t impact your REPAYE or IBR eligibility. However, filing separately won’t lower your REPAYE payment.
I know I’m giving you mostly bad news here, but it sounds like IBR is your best option based on your comment. That said, if you have any questions or concerns, I’d encourage you to call your servicer for clarification. They can pull up your account and look at your loans to verify eligibility.