If you are married and you or your spouse have student loans, taxes get extra complicated.
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 cover ways to help you spend as little as possible.
Step 1: 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. The major benefit to 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.
The tax brackets work differently if you are married filing separately, and you will have to pay more to the IRS if you file separately. 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.
Step 2: Take a look at your repayment options
The Department of Education actually 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 definitely better than IBR, but if you have student loans from before October of 2007, you are not eligible for PAYE. REPAYE (Revised Pay As You Earn) was created so that everyone is able to limit student loan payments to 10% of their discretionary income. Unfortunately, REPAYE doesn’t care how you file your taxes. Whether your file jointly or separately, your spouse’s income will be included in the calculation.
In short, figure out how much you can save by filing separately. This is your potential savings.
An Important Reminder
The decision isn’t quite as simple as just picking the option that costs less money. 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 somewhat of a variable, if the numbers are close, it might make more sense to opt for the higher student loan payment because it is reducing your debt while the higher tax bill is of no benefit at all.
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 actually growing because your monthly payments are less than the interest, your servicer is tracking the extra money each month. It isn’t 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.
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.