One of the great perks of having federal student loans is the income-driven repayment plans. These plans, such as Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE), charge monthly payments based upon what borrowers can afford to pay instead of how much they owe. Borrowers who make payments for 20 to 25 years also get their remaining loan balance forgiven. Unfortunately, there is a major downside to this forgiveness.
Borrowers on Income-Driven Repayment plans may receive a large tax bill if their debt is forgiven after 20 or 25 years. While there are some steps borrowers can take to avoid the tax bill, it is a good idea to plan for the extra tax.
Most borrowers can prepare for the tax bill long before it comes. Borrowers should also be sure to avoid one common mistake.
The Student Loan “Tax Bomb”
The “tax bomb” as many borrowers affectionately call it is the huge tax bill that comes when the student debt is forgiven. The IRS treats most forgiven debt as income the year it is forgiven. That means if you make $30,000 per year and have $90,000 worth of student loans forgiven, the year the debt is forgiven; the IRS will tax you as though you earned $120,000.
For many student loan holders, this tax bomb represents a significant issue in the future. In some cases, their monthly IBR payment is less than the monthly interest on their debt. When this happens, the loan is said to be negatively amortizing. The student loan balance is actually going up rather than down. After 25 years of growth, the student loan balance can become quite large.
Avoiding the IBR Tax Bomb
There are three ways in which the large tax can be avoided.
- Pay off the Debt in Full – This may seem to be an obvious suggestion, but it is something for borrowers who have the money to pay off their debt to consider. In some cases, chasing after student loan forgiveness can be more expensive than just paying off the loan. A borrower who can pay off their debt in 10 years might spend far less than a borrower who pays the minimum for 25 years. This is because of the many years of extra interest and the large tax bill at the end. Which route is best will depend upon your loan balance, interest rate, and ability to pay.
- Public Service Loan Forgiveness – The Public Service route is appealing because the loans can be forgiven after just ten years, and under Public Service Loan Forgiveness, the forgiven debt is not taxed. The key is to find a job working for the government or a non-profit. However, be sure to understand all of the fine print with Public Service Loan Forgiveness. The Department of Education strictly enforces the requirements.
- A Change in Policy – There is bipartisan support to change the tax laws so that the student loan tax bomb does not happen. That being said, any financial plan that is dependent upon Congress acting is probably ill-advised. Nonetheless, it would be wise for affected borrowers to watch the news and voice their support for any laws that would improve the tax treatment of student loans.
Even if the tax bomb cannot be entirely avoided, there are ways to limit the damage done.
Steps to Take to Prepare for the Student Loan Tax Bomb
Smart financial planning can go a long way towards minimizing the tax bill when your student loans are forgiven. Because this is a major tax strategy issue, it would be wise to discuss the looming tax with your tax preparer so that you can limit the damage.
Additionally, a savings account can be created to start saving for the sizeable future tax bill. With 20 years to prepare, saving a little bit of money each month can add up by the end. Best of all, if the tax law changes, you have a nice chunk of change set aside for retirement or another financial goal.
When it comes to managing your student loans, there are also a couple of tactics that can be used to prevent the balance from spiraling out of control.
- Sign up for the Revised Pay As You Earn Plan – Deciding which income-driven plan is best can involve several different factors (it is a subject we recently examined). One valuable aspect of the REPAYE plan is how it treats excess interest. Unlike IBR and PAYE, half of the extra interest is immediately forgiven. That means if your loan balance is generating $100 of extra interest per month, only $50 of that will ever be added to your balance.
- Avoid Interest Capitalization – When the interest on your account is growing your student loan balance, the extra interest isn’t immediately added to your balance. It sits on its own, waiting for an event to trigger it to be added to your principal balance. Keeping the extra interest out of your principal balance is a good thing because it means you won’t have to pay interest on the interest. For larger balances, this can make a huge difference. Missing an income certification deadline can trigger interest capitalization, so be sure to understand what triggers interest capitalization and how to avoid it.
One Mistake to Avoid
Some borrowers have suggested paying a little extra on their student loans to keep the balance low. By keeping the balance lower, these borrowers are trying to reduce the potential future tax bill.
The problem with this approach is that it would be a poor allocation of resources. Suppose that in the future, when the giant tax bill comes, the borrower is in the 25% income tax bracket.
By paying an extra $10,000 over the years, the borrower would reduce the eventual big tax bill by $2,500. In other words, by paying an extra dollar now, the goal would be to save 25 cents in the future.
The math isn’t quite that simple because the tax brackets can change. The payments may also reduce the principal balance, which could lower the tax bill by more than 25%. However, regardless of how the math shakes out, spending money to reduce the amount forgiven is a lousy investment.
Funds will go much further if they are set aside for the future tax bill. Plus, if the tax laws ever change, borrowers keep 100% of the money they set aside in savings.
Getting student loans forgiven is great. A huge tax bill makes getting the debt forgiven slightly less great. The good news is that many steps can be taken now to reduce or eliminate the tax bomb issues of the future.