Student loan repayment can get complicated for married couples.
If you are on an income-driven student loan repayment plan, such as IBR or PAYE, how you file your taxes can have a huge impact on your monthly payments. File jointly, and your spouse’s income affects how much you pay. However, REPAYE, another popular income-driven repayment plan works differently.
Today we will look at the advantages of filing separately and cover the many reasons why filing separately isn’t an easy decision.
What is the advantage of filing separately?
Federal student loans come with a variety of income-driven repayment (IDR) plans. The IDR plans allow borrowers to make payments based upon what they can afford rather than what they owe.
In the case of married couples, the government will count the income of both spouses when determining how much a couple can afford to pay for their student loans.
One way to avoid counting spousal income for IDR payment calculations is to file taxes separately. By filing taxes as married filing separately, spousal income isn’t factored into the IDR calculations, except in a few circumstances detailed below.
What if we both have student loans?
This issue primarily applies to couples where only one person has student debt.
In couples who both have student loans, it usually doesn’t make sense to file separately. Payments may change slightly, and the math can be a bit confusing, but if you both have federal student loans, you will usually want to file jointly.
Even though the answer is usually straightforward for couples in this situation, it is still a good idea to understand the pros and cons of filing separately versus jointly. This is especially true if one spouse will eliminate their debt long before the other, such as couples where one person may soon qualify for Public Service Loan Forgiveness.
Do your taxes… twice
The question of filing jointly or separately does not have a simple answer, and the results can vary from one couple to the next. Enter math.
The major benefit of filing separately is that you end up with lower student loan payments. However, those lower payments come at a cost. That cost is in the form of higher taxes.
In the past, this cost was attributed to a change in tax brackets as there was a clear penalty for filing separately. Recent changes to the tax code have reduced or eliminated this particular penalty for most taxpayers.
Even though the tax bracket issue is much less of a problem, filing separately is still likely to be the expensive alternative. The only way to know how much is to do the math. Prepare a joint return, and then two individual returns. The cost of filing separately is the extra taxes that you will have to pay on those two individual returns.
Why is filing separately more expensive?
Filing separately means that a couple is no longer able to claim many popular tax deductions and credits.
- Earned Income Tax Credit
- American Opportunity and Lifetime Learning Education Tax Credits
- Exclusion or credit for adoption expenses
- Child and Dependent Care Tax Credit
Most noteworthy for student loan borrowers is that the student loan interest deduction is lost by filing separately.
Couples that wish to deduct the student loan interest must file jointly.
Consider your repayment options
The Department of Education makes this step pretty easy. They have created this wonderful tool called the repayment estimator. Using this resource, you can find out what your student loan payments would be in a variety of circumstances.
Use the repayment estimator to figure out your monthly payments if you file separately and your monthly payments if you file jointly. If you have any questions about plan choices or monthly payments, be sure to call your servicer so that you understand all of the options and limitations.
When you look at the repayment plan options, keep in mind that filing separately only helps borrowers who are signed up for the IBR (Income-Based Repayment) plan or the PAYE (Pay As You Earn) plan. IBR limits your student loan payment to 15% of your discretionary income, while PAYE limits your student loan payment to 10% of your discretionary income. PAYE is better than IBR, but if you have student loans from before October of 2007, you are not eligible for PAYE.
Don’t file separately for REPAYE
REPAYE (Revised Pay As You Earn) was created so that everyone can limit student loan payments to 10% of their discretionary income. Unfortunately, REPAYE doesn’t care how you file your taxes. Whether you file jointly or separately, your spouse’s income will be included in the calculation.
Borrowers with older loans may be forced to live with the 15% requirement of IBR if they file separately.
Keep an eye on capitalized interest
If your monthly payments on IBR, PAYE, or REPAYE are less than the monthly interest that accrues each month, you should also give some thought to capitalized interest.
When your loan balance is growing because your monthly payments are less than the interest, your servicer is tracking the extra money each month. It isn’t immediately added to your principal loan balance. Instead, they just keep a running tally of this additional money you owe. By not adding it to your principal balance, you avoid paying interest on that interest.
Switching repayment plans causes the accrued interest to be “capitalized”, meaning it gets added to your principal balance. When you have interest capitalization, your balance goes up, and your monthly interest payment also goes up.
Thus, if you are on an income-driven repayment plan paying much less than the interest that the loan generates each month, switching repayment plans will increase your loan balance very quickly. As a result, if you are in this situation and the numbers are close, it might make sense to choose an option that does not require you to change repayment plans.
An Important Reminder
The decision isn’t quite as simple as just picking the option that costs less money. It is also essential to consider how this decision fits in with your overall student loan plan and tax strategy.
Remember: student loan debt is money owed to the federal government. Getting lower payments does not mean you will owe the government less. In fact, the opposite is true. The less you pay now, means more interest will accumulate, and you will pay more in the long run.
However, if you are certain you will be qualifying for loan forgiveness, the decision is then just a simple comparison of which option saves you the most money for the next year.
Because student loan forgiveness is a variable, if the numbers are close, it might make more sense to opt for the higher student loan payment. This route keeps taxes lower and reduces a debt that may have to be paid in full.
Filing Separately in Community Property States
Borrowers that live in a community property state will have an extra layer of complication.
The following states have community property rules: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
In community property states, couples that file separately must each report half of all community income on their tax return.
- During your marriage
- While you and your spouse are living in a community property state
This strange income reporting rule can lead to some odd outcomes when doing the math on the best way to file. This site has previously taken an in-depth look at how couples in community property states might have to adjust their repayment strategy.
On the surface, the decision to file jointly or separately is one of just picking the option that costs less. In many cases, it comes down to just doing the math and picking the less expensive choice.
However, it can be beneficial to think not just about next year, but the next 10 or 20 years, when you make this decision. Concepts like student loan forgiveness and capitalized interest can potentially sway your decision.
If you feel overwhelmed about your choices, this might be a situation where you do all the research you can, think about your future plans, and then discuss things with a financial planner or an accountant.