One of the major perks of having federal student loans is that there are repayment plans based upon what you can afford to pay rather than what you owe. These Income-Driven Repayment plans ensure that federal student loan payments stay reasonably affordable.
Things get tricky for borrowers who come into money they were not expecting and will be getting only once, such as those who receive a gift or an inheritance.
The good news for most recipients of a gift or inheritance is that the extra money won’t usually increase student loan payments. For those who fall under an exception, there is a workaround to keep payments reasonable.
What does an Inheritance have to do with Student Loans?
To see how this issue can play out, we turn to a recent email. One of our readers, Daphne, is concerned about her student loan payments going up due to an inheritance she is going to receive.
Dear Student Loan Sherpa,
Thank you so much for this amazingly helpful resource. I have spent hours scouring articles and forum questions, and although I have gleaned and confirmed valuable information, the topic of my question has not been directly addressed. I am on year 3 of a 25 year IBR plan. (15% discretionary income and 25 years to forgiveness). Currently, my payments are at zero as I have not been working due to illness.
If I were to either inherit or be gifted a large lump sum (larger than the loans total, which has grown to about 75k because of capitalized interest), how would that affect my payment plan for that year and ongoing? I have spoken to 5 different people, both at the Dept of Ed itself and my servicer Nelnet, who all said the same thing but could not direct me to where I could find the answer in writing. I was told that since inheritance or gift is not considered income, it would not affect my repayment. I understand that if the lump sum is invested, the accrued income would then be considered income.
The Basics – IDR Calculations
When we talk about income-driven repayment plans, such as IBR, one of the key benefits is the fact that the plans are designed so that borrowers can afford their student loan payments regardless of how much they owe. Daphne thinks, quite reasonably, that if she gets a large inheritance or financial gift, she would be expected to pay more towards her student loans.
Fortunately for Daphne, the formula that the government uses for determining how much you can pay is pretty simplistic. They consider your state of residence, family size, and most recent tax return. Using this information, your loan servicer calculates your discretionary income, and from that number, your monthly payment. To see this calculation in action, be sure to check out the Department of Education’s Repayment Estimator.
Adjusted Gross Income – The Important Number
The key figure on your tax return is the adjusted gross income. As this number goes up, your income-driven student loan payment increases. If it goes down, your student loan bill will drop.
Daphne’s question comes down to a tax question. Does an inheritance or financial gift have an impact on your adjusted gross income? If the inheritance is treated as income, it will increase her student loans. If it isn’t taxed, there will be no impact on her student loan payments.
Inheritance Taxes and Student Loans
To find out for certain whether or not an inheritance or financial gift will increase your student loan payments, you will need to talk to an accountant. The accountant who prepares your tax return will know for sure whether or not it will increase your AGI.
Generally speaking, inheritances are not taxed on the beneficiary. This means that the person giving the money has to pay tax on it, not the one receiving it. We recently discovered the same thing when looking at gift taxes as well.
However, it is worth noting that even if it is not taxed at the federal level, there still might be state taxes, depending upon where you live. The good news is that even if there are state taxes, it won’t change your student loans.
The Dreaded Exception and How to Get Around It
Unfortunately, the basic rules do not apply to all inheritances.
The most common example would be those that receive a traditional IRA or a 401(k) inheritance. The retirement accounts contain funds that have not yet been taxed. The recipient of the account will then be responsible for paying the tax on the income.
The beneficiary of an IRA or 401(k) will usually see a temporary one time jump in their Adjusted Gross Income (AGI). This can mean higher student loan payments. Here again, a good accountant or tax preparer can provide exact numbers and options for dealing with the tax spike.
The good news is that a recent tax return isn’t the only way to certify income. Borrowers who have a tax return that doesn’t accurately reflect the money they are earning can submit alternative documentation of income. Typically, this alternative documentation takes the form of providing a couple of recent paystubs. The process isn’t always as simple as pulling a recent tax return, so a phone call to your servicer can help avoid any potential issues.
The system for calculating a borrower’s ability to make student loans is fairly simple. It all comes down to the AGI on your most recent tax return. In Daphne’s case, this is a major benefit because it means an inheritance likely won’t increase her student loan payment.