Understanding your options for repaying your student loans before making a decision will help you avoid some of the most common, and most costly, mistakes you can make. Be sure to avoid the worst repayment plans and consider the tax consequences of any decision you make.
4 Worst Repayment Plans for Student Debt
There are four payment plans you should never select: graduated, extended, new income-based repayment (IBR) and income-contingent repayment (ICR). Many people select extended or graduated repayment plans because these two plans often provide the lowest initial payments, and when you are young and fresh out of college, every penny counts. However, the extended and graduated plans end up being the most expensive ones in the long-run. Extended and graduated plans do not qualify for public service loan forgiveness (PSLF) or long-term debt forgiveness. Meaning, when you switch to a new payment plan, all those payments you made under the extended or graduated plan did you very little good, other than maybe keep your interest costs from spiraling in the wrong direction.
Selecting new IBR as your payment plan is a bad idea because if you qualify for this plan, you also qualify for the pay as you earn repayment plan (PAYE), which is better. When interest capitalizes, PAYE limits the amount of interest added to 10% of the balance. Whereas, interest capitalization with the new IBR plan is uncapped. In layman's terms, PAYE is less expensive than new IBR.
ICR is the last of these offenders. Payments for the ICR plan are 20% of discretionary income vs. 10% - 15% with the other income-based plans. (For related reading, see: Student Loans: Paying off Your Debt Faster.)
Tax Impact of Choosing Long-Term Forgiveness
There seem to be a good number of young professionals who are planning to get their debt forgiven in 20-25 years using the long-term route. Unfortunately, a large percentage are unaware that when their debt is forgiven (without PSLF) the remaining loan balance is added to their taxable income the year it is forgiven.
If you are making $150,000 25 years from now and you have $90,000 in student debt being discharged, your income for that year will be $240,000. Using the Trump tax reform rates, that extra $90,000 drops a tax bomb of $29,400 in the borrower's lap. The key here is to make sure you have a savings plan in place to pay the tax bill later on. (For related reading, see: No Debt Forgiveness for the Tax Man.)
Filing Your Taxes Separately Will Not Reduce Monthly Payments
The other big tax mistake is for a young married couple to file their tax returns separately with the sole purpose of reducing monthly student loan payments. This can be a good strategy, however, simply filing separately while failing to consider the implications is a huge no-no. The general "formula" for deciding the cost-benefit of filing jointly versus separately is to compare the total tax costs against the annual cash savings that would result from lowering monthly payments on your student debt.
The borrower needs to project the potential tax liability at the end of their loan period (20-25 years), as well as calculate the annual tax increase/decrease for filing their returns as married separately. Anything in the surplus side would suggest filing separately is a good financial plan.
There are other mistakes that you can make when paying off your student loans, including:
- Forgetting to re-certify your IBR plan on your anniversary date;
- Failing to certify automatically bumps your payments up to the standard 10-year payment plan;
- Not verifying PSLF credits and assuming your employer is a 501(c)(3);
- Taking on too much private debt; and
- Allowing interest to accrue, snowball and capitalize.
Understanding the ramifications of each type of student loan repayment plan and potential tax implications of debt forgiveness and how you file your returns can help you make the right long-term decision.
(For more from this author, see: A Roth IRA Savings Strategy for High Earners.)
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