Those breathing a sigh of relief that their student loan payments are now in line with their income may want to re-examine the rules that set the payment in the first place. There could be a tax time bomb looming, slowly ticking away. And defusing it is not a big part of the policy discussion in Washington at the moment.
This potential tax bill is a byproduct of federal efforts, including the newly expanded income-based repayment program, that allow you to limit the monthly payments on most federal loans to what you can afford to pay. There’s a formula that uses your income to determine your payment. Then, the federal government forgives any remaining balance, usually after 10 to 25 years.
The catch comes with the forgiveness, since you generally have to pay income taxes on any forgiven debt (unless you were in a program for teachers or worked in a public service job, in which case the taxes go away). For many people, especially those who finished graduate or professional school with six figures of debt, the tax bill could be well into the five figures. And when it comes, you are supposed to pay in full, immediately.
Figuring out just how many people will be in this situation — and just how high the tax bill could be — is a tough task, and not many experts have tried it.
Sorting it all out begins with the repayment programs themselves. Some people signed up for income-contingent payments back in the 1990s. The income-based program came along more recently, and the Obama administration then tweaked it to make it more generous by shortening repayment periods and adjusting the formula used in figuring out the monthly bill.
As of Oct. 31, about two million people had applied for income-based repayment, according to Education Department figures. About 1.3 million had low enough income and high enough debt payments under standard repayment plans to qualify for reduced payment under the terms of the program. Another 440,000 applications were still pending.
In the 2011-12 school year alone, more than 10 million people took out the popular federal Stafford student loans, according to the College Board’s Trends in Student Aid report. Cooper Howes, a Barclays analyst, estimated in a report earlier this month that more than half of all borrowers would be eligible for payment reductions because of their incomes.
If you or your children are borrowers and the income-based repayment program is new to you, you should consult the Project on Student Debt’s ibrinfo.org site, which is about as clear as this complicated topic can get. The Education Department’s site is worth a thorough look, too, as is the New America Foundation’s income-based repayment calculator. I’ve stuffed the Web version of this column with links to these and other pertinent information sources.
Trying to pinpoint the scope of the looming tax issue starts to get more complicated pretty quickly. Not all eligible students will sign up for income-based repayment, since some will not hear about it, will ignore it when they do, will assume or be told (incorrectly) that they can’t qualify or will worry that there is some kind of catch. For those who sign up, it’s awfully hard to predict how many will eventually have some debt forgiven a couple of decades from now.
But Jason Delisle, who has written extensively about the income-linked repayment programs as director of the federal education budget project at the New America Foundation, points to an Office of Management and Budget effort that took a stab at it. The O.M.B. assumed that 400,000 borrowers from 2012 through 2021, each with a beginning average loan balance of about $ 39,500, would each eventually receive loan forgiveness of about $ 41,000. Yes, you read that right. The forgiven debt will be more than the original balance, albeit many years later.
At $ 41,000 of loan forgiveness, the federal tax bill could easily be over $ 10,000 depending on your tax bracket. There are also state income taxes to contend with, depending on where you live.
But the numbers can go much higher. Stephanie Day earned her bachelor’s degree in her 40s after a divorce, intending to enter the field of social work. She finished in the depths of the recession and could not find work, so she returned to school to get a master’s in psychology to bolster her credentials.
Even then, the jobs available near her home in Seattle were slim, so she moved to a town on the border of New Mexico and Texas for a position there. One home invasion and 12 months of misery at being apart from her children later, she’s now back in Seattle and paying just $ 30 each month on her $ 80,000 or so in debt via the income-based repayment plan.
Ms. Day has run the numbers and can foresee a situation where the government will forgive more than $ 100,000 of her debt, given that her unpaid balance keeps growing thanks to the low payments. And while she expressed dismay that so few people were aware of the tax bill in their future, she does not necessarily mind paying it. “I think it’s perfectly fair,” she said. “I guess I’m old school.”
Mr. Delisle, of the new America Foundation, however, would like to see student loan debt forgiveness become a tax-free event for everyone, and not just people who have worked as teachers or in public service jobs. “Think about it practically,” he said. “You forgive someone’s loans, then you stick them with a tax bill that’s equivalent to making three or five or 10 more years of payment on the loan.”Representative Sander M. Levin, Democrat of Michigan, has tried and plans to continue to try to get a law passed that will take away the tax burden, according to his spokesman. The odds of this happening anytime soon, however, are probably pretty low in the current political environment.
That said, Mr. Delisle has also expressed alarm about how professionals with reasonably high incomes — but a couple of hundred thousand dollars in graduate or professional school debt — could benefit disproportionately from forgiveness a few decades from now.
Some people see opportunity in that fact. A company called the Advantage Group in San Diego is teaming up with investment advisers and insurance agents to advise high-debt individuals on how to maximize the benefits of income-based repayment. Its business model is to take a cut of whatever those financial professionals earn, say through commissions, when those professionals persuade their debt-laden clients to set aside money to pay the eventual tax bill. The commissions would come from those professionals’ selling investments to the people who have set the money aside.
Jantz Hoffman, who started the Advantage Group after a veterinarian friend with more than $ 200,000 in federal student loan debt sought his help, says he thinks that plenty of people could see a tax bill of tens of thousands of dollars one day.
“Let’s say your debt has grown to $ 180,000 over 20 years, and by that point, you’re making $ 120,000,” he said. “If $ 180,000 is being forgiven, then you’re looking at paying taxes on $ 300,000 in total income in one year. At that point, you’re over the $ 250,000 income category, my friend.”
It’s wise to be a bit wary of anyone aligned with insurance agents pitching investments. And worries about a tax bill a couple of decades from now shouldn’t scare you away from signing up for the income-based repayment plan if you need it. But however the numbers turn out, anyone enrolled in the plan ought to be thinking hard about salting away some money, somewhere, for the eventual tax bill.
After all, no matter how high the bill, there are severe penalties for not paying it right away. The Internal Revenue Service, alas, does not have an income-based repayment program.
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