Liz really impressed me with the need to wake folks up to the dangers of cruising along with an income-based student loan repayment plan, so I asked her to stop by here and explain. (Plus of course I’m all about waking folks up to the dangers of cruising along with ANY type of debt.)
What income based plans are
Income based student loan repayment plans became available in the wake of the recession as legislators realized that many were struggling with the minimum payments the standard ten-year repayment plan offers.
With the cost of education soaring, the average college graduate graduates with $30k in student loan debt. Graduate students finish with even more. Due to the heavy financial burden, the government implemented Income Based Repayment plans for those who qualify.
If you qualify, you won’t pay more than 15% of what they deem your discretionary income. After 20-25 years of payments than the rest of your student loans are forgiven. On the surface, this sounds great, payments you can afford and anything you don’t pay back gets forgiven.
But there is a catch, the amount forgiven is considered taxable income. Meaning that if you end up with $10k in student loans forgiven and you make $40k a year, you will be taxed as if you had made $50k that year, increasing your tax bill.
Now being taxed on $10k when you started with $30k in loans isn’t that bad overall a $3k tax bill is doable, and I’m sure a reasonable payment plan could be negotiated. (Jackie’s note: I wouldn’t want to have to negotiate with the government.)
A different scenario
However, what if you started with $100k in student loans with interest rates in the 8-9% range? Those loans would cost you $21 in interest PER DAY, meaning you would have to make a payment of over $650 each month just to cover the interest. However, with the Income Based Repayment plan you are only required to make a payment of $450 a month. You aren’t defaulting on your loans because you continue to make payments, but you aren’t even covering the interest each month.
So instead of paying your loans down, the amount you owe is actually growing, and the amount of interest on your student loans gets bigger and bigger. After 20-25 years, you no longer owe $100k but closer to $200k. When $200k is being forgiven, you are looking at a $60k tax bill, which is much more difficult to manage if you are only making $40k-60k per year.
Consider what could happen
Income Based Repayment plans can be great if you are just out of school and struggling to make ends meet: they let you pay your bills and be strategic about paying off your debt. This only works if you are being strategic about your finances and using the lower payments to throw extra money at a particular debt (a great reason to be using the Pay Off Debt App.
If Income Based Repayment is your only plan, then you might want to crunch some numbers and see just how much in taxes you could be paying when you are 45-50 years old.
Exceptions to the rule
Now I should mention that there are some exceptions to the rule that you will be taxed on the amount forgiven. The first is if you complete the 10-year Public Service Loan Forgiveness program. The second is if you can prove you became insolvent right before the loans were forgiven.
I fully support getting rid of your loans via the first option of the Public Service Loan Forgiveness Program. Though if you are hoping to be insolvent at 50 just so you won’t be taxed on your student loans, just when exactly are you planning to retire?
At the end of the day, Income Based Repayment plans can be great to help you get started with getting your finances in order, but don’t get comfortable with them in the long run.
Liz blogs over at Less Debt More Wine where she writes about paying off her debt while creating a beautiful life for herself through DIY. You can head over there to get a FREE guide to Flexible Student Loan Repayment Plans to understand what is available and what loans qualify.