Income Based Repayment of Student Loans Still Better Than Doing Nothing At All

There’s a dangerous trend I’ve seen repeatedly with individuals in income-based repayment (IBR) plans for their student loans, and it’s clear to me there’s a critical piece of information missing from our general understanding of how these programs work.

Income-based repayment (IBR) plans are offered on federal subsidized and un-subsidized student loans in an attempt to make high student loan debt more manageable to pay off. They extend the repayment term from the standard 10 years to either 20 or 25 years, and cap monthly payments at 10% or 15% of discretionary income depending on the program. However, two other features of these plans are responsible for a potentially epic problem looming in the future when the term ends: If your income is low enough, you could qualify for a payment that doesn’t cover the accumulating interest, and possibly even pay nothing. At the repayment term’s end, the remaining balance is forgiven.

The second point may sound like a positive, but there’s a catch: any remaining IBR loan balance that is forgiven at the end of a 20- or 25-year term is considered taxable income by the IRS.

Without knowing that one detail, you might happily fall into a group of graduates who’ve acquired substantial student loan debt, but are not in a financial position to pay them off immediately. Maybe you graduated with job prospects that place you in potentially lower-income lines of work. Your plan is to pay nothing on your loans and wait until they are forgiven.

The Downside of Not Paying Off Your Student Loans

For many college graduates, it’s easy to come out after two years owing $100,000 in loans with an average of 6.5% annual interest. If you stick with the standard 10-year loan term, you’d be required to make monthly payments of $1,135, which is no easy task, so the idea of sliding under the radar for a couple of decades may sound appealing.

If you qualify to pay nothing and stick with it, your loan interest, accruing at 6.5% annually, could bring the balance of your loan beyond $500,000 in 25 years. This amount would be forgiven, but it would also be reported as income on a 1099-C and sent to the IRS.

A half-million dollars of income in one year for single filers in my home state of New York (at 2017 income tax rates) will result in a tax bill north of $200,000. This may arrive at a time when you could be sending your own kids to college, setting your eye on retirement, or perhaps you’re just sick of the hustle and wanting more financial padding in your life.

If you aren’t able to come up with the entire amount due, you’ll likely be subject to more penalties and interest as you get onto the treadmill of another painful payment plan, and a possible bankruptcy filing down the line (presently three tax years after the tax becomes due to the taxing authorities – assuming you meet all of the other criteria then in effect to determine your eligibility to file any form of consumer bankruptcy)

Misleading Information About Loan Forgiveness

In a simple Google search I found misleading financial articles touting loan forgiveness as a secret strategy for getting off scot-free, with the potential tax bill given a quiet mention at the end. I’ve also had clients tell me about debt counselors offering up the “pay-nothing” solution, going so far as to advise loan-holders to file taxes separately from their spouses to keep their income as low as possible. This means that along with accruing interest, they’re likely paying higher annual income taxes, as the married filing separately option generally disqualifies taxpayers from common deductions and results in a higher tax bill.

IBR plans assume a 5% increase in salary per year, so for most people, even if they start off on the low end of the income spectrum, in all likelihood they’ll be debt-free before the clock strikes 25 years. The people I am worried about are the ones whose educations are inordinately expensive and who graduate without a clear income path, which I see frequently with people in creative fields. Many of these folks have honed ninja-level frugality skills, which allows them to keep the “pay-nothing” plan going without realizing where they’re headed.

I’m not saying IBR plans are always a bad choice—they’re not. And if you’re at least covering the interest with your monthly payments while your income grows steadily over time, they may be your best option.

But for those who think they’ve found a loophole. I assure you, the IRS has seen this strategy coming a mile away and has a painful way to disincentive it.