Beware of Student Loan Repayment Programs

An alphabet soup of alternative student loan payment programs has made repaying your loans more complicated than ever. Choosing the wrong plan can cost borrowers tens of thousands of dollars, and it practically takes a masters in tax and finance to figure out which approach is best for you.

Lets consider for a moment the income-based repayment program. Or shall we say programs, because there are at least four different versions, each with a different acronym and different rules. 

Income-Based Repayment

In general, all the programs work in much the same way. If your income is low, but your indebtedness is high, you can use the programs to reduce your monthly payment so that it is no more than 10-15% of what the government considers your discretionary income. Discretionary income is your income, less an allowance for basic living expenses. If after a period of 20-25 years, you still have not repaid your loans, they will be forgiven, and the government eats any remaining balance. If you happen to work for a government or non-profit employer, your loan will be forgiven after only 10 years!  Sound good so far? Well, borrower beware, because this gift from the government is a Trojan horse for many! 

What borrowers often do not appreciate is that until the loan is forgiven, interest will continue to build on the loan balance. This is referred to as “recapitalizing” the interest. Let's say you owe $60,000 and the interest rate is 6%. Further, let's assume you make very little money and don't have to make any payments for 20 years. By the time the 20-year repayment period is over, the amount owed will grow to $192,000!!! 

“But so what?” you may think, “The balance is being forgiven anyway, I don’t care how big it gets”. Oh but the IRS cares. That entire $192,000 loan balance will be taxable income to most borrowers in the year it is forgiven. Your tax bill on that forgiven loan could be as large as the entire original loan balance, and the IRS is not nearly as flexible as the Department of Education when it comes to repayment! I should note here that public service loan forgiveness is not taxable, making it even more attractive to work in the government or non-profit sectors if you have a lot of debt. (For related reading, see: No Debt Forgiveness for the Tax Man.)

The increasing debt balance also becomes a problem if your income increases or if you get married to a higher income partner and file a joint tax return. In both cases, monthly payments may skyrocket as payments are increased due to the recapitalized interest. 

Student Loan Repayment and Marriage

While we are at it, let’s consider marriage, because this can become another trap. Let’s say Johnny borrowed $60,000 and is now earning minimum wage while he waits for his big break. He can’t afford payments on his student loans, and is using the income-based repayment option, which cut his payment almost to zero. He falls in love with Julie, who has a good paying job making $90,000 per year and they get married and have a baby. Johnny decides to stay at home and take care of the baby, so now has no income of his own. If the couple files a joint tax return, Johnny will now have to start paying the full amount of his student loan debt, which has been growing rapidly due to recapitalized interest. If they file separate tax returns, Johnny will not be required to make any payments on his loan (this is permitted under three of the four available income-based repayment options). But is that the best approach for the couple? 

Not necessarily. I asked John Perez at Kaufmann Diamond CPAs in Somerset, NJ to run a hypothetical tax scenario for me. If Julie files separately as head of household with two exemptions and a standard deduction she might expect to pay about $12,000 per year in federal tax. Johnny, filing separately, would pay nothing. If they file jointly, with three exemptions and two standard deductions, they might only pay $8500. The tax savings from filing a joint return might pay for some or all of the additional debt payments resulting from the higher income. It would cost Johnny nothing and allow him to start paying down his debt, instead of letting it grow into a mountain of future taxable income.

So be wary of the siren song of debt forgiveness. It is an extremely complicated program with many traps and pitfalls awaiting the uninformed. It is worth a small investment to speak with a financial planner or tax professional who is familiar with the intricacies of student loans, and can steer you to the option that makes the most sense for your unique financial situation.   

(For more from this author, see: Pacing Yourself Is Important in Retirement and Running.)