The Unforeseen Downside of Income Based Repayment
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UPDATED: Dec 19, 2012
When the Income-Based Repayment (IBR) program started in 2009, student loan borrowers were given a way to survive their mounting debt obligations.
But not everyone read the small print.
Many borrowers were unaware of the hidden tax fees linked into IBR. High income taxes loom for any borrowers who are absolved of their federal student loan debt under the repayment program.
Although monthly payments will be significantly reduced for borrowers approved under IBR, the amount of income taxes that will amount can grow to upwards of five figures. And this tax is not under an installment plan: it must be paid immediately to the Internal Revenue Service (IRS).
IBR Program Breakdown
IBR is a repayment plan available for several major types of federal student lending. The program caps the borrower’s monthly payments at an amount that is based upon family size and income. The monthly payment will be 15 percent of a borrower’s discretionary income. Any remaining debt left over after 25 years of consistent repayment will be forgiven. If a person works in the public sector, the debt will be forgiven after only 10 years, as it is considered a part of the Public Service Loan Forgiveness (PSLF) program.
Before signing up, borrowers can calculate their personal projected monthly bill that will be awarded under the IBR program.
However, calculations do not project the cost of future tax obligations required of IBR participants.
Even for the newer repayment plan, Pay As You Earn, which caps the payment period at 20 years and a 10 percent discretionary income, the future tax obligations are still present.
The IBR program is only offered for some federal student loans, but since most student loans are federal and not private, it will greatly impact the student lending sector. According to Education Department figures for Oct. 31, 2012, around two million people have applied for the IBR plan.
But with so many people in a program with confusing rules and regulations, what is the fallout for those that ignore the small print?
Solid Advice, But No Easy Ride
Jantz Hoffman, managing partner of The Advantage Group, said his company handles student loan and taxes questions of this kind daily. The Advantage Group, a provider of financial advice for professionals with student loan debt, specializes in federal programs such as IBR and PSLF.
Although all of The Advantage Group’s clients know about the future tax cost, such cannot be said of all IBR participants. Hoffman said a lot of new clients come to the group for this exact help.
“Usually the people that come in here just graduated,” Hoffman said. “They couldn’t tell you what types of loans they had.”
He said they might have heard about IBR at one point, but they do not know about the multi-faceted implications of the program.
One of Hoffman’s clients is an associate dentist with $450,000 in federal student loan debt.
“There is zero chance that she is ever going to pay off that student debt,” he said.
For general calculation purposes, if her $450,000 in student loans is at a 7.2 percent interest rate, and she makes an annual gross income of over $236,000, she will need to pay around $37,000 in simple interest per year. If she enrolls in the IBR plan, she will pay the $37,000 in interest per year, which is about $3,083 per month, for 25 years. But that exorbitant monthly payment only covers interest, and does not touch the principal cost. So after the IBR program’s 25-year term, she will have the full $450,000 in debt forgiven.
The debt will be forgiven, but her taxes will continue to haunt.
Since she makes about $236,000 per year, and is absolved of $450,000 in debt, that will put her total taxable income at about $686,000. This higher income bracket, according to Hoffman, will cost her about $220,000 in taxes for that year. And this is after paying $37,000 per year for 25 years. After all is finished, the dentist will have paid over $925,000 in IBP payments, plus her large income tax payment of $220,000 which equals a staggering cost $1,145,000.
Clearly, the plan is not a financial saving grace for everyone.
Even though the cost is extraordinary in this inflated case, Hoffman said he would still enroll this client in the IBR program. It just comes down to preparing for that tax cost in the future and setting aside money now and allowing it to grow in a savings account.
Cases of Absolution
In some cases, the extra income tax cost can be absolved.
For non-public sector employees, this tax cost will not disappear. The only exemption is for public sector employees. If they are enrolled in the PSLF (Public Service Loan Forgiveness) Program then their incomes taxes will not take a hit. But for everyone else, it will.
Even for those rare few that have student loan debts completely forgiven, the discharged debt will still be taxed. This creates a huge problem for those individuals.
The weight of discharging large student debt is only loaded with another fear: the IRS. The IRS views most types of cancelled debt to be taxable income. Cancelled debts over $600 must be reported to the IRS on a 1099-C form.
Any discharged debt, whether it is $10,000 or $150,000, is taxed the year that it is discharged. This discharged debt will be added to the regular income taxes, creating a spike in some citizen’s income taxes.
“I think the government is going to have a hard time collecting that money on a lot of people,” Hoffman said.
This IRS fee is the same currently being seen in the mortgage field, in the case of short sales. Although short sale taxes were eradicated, they will be reinstated in 2013, according to Hoffman. For short sales, if someone sells a home for less than it is worth, there is an amount of principal balance that is forgiven. This balance will be taxed later.
Taxation as a Necessity
Each government program has its pros and cons. Although some have stronger potential for helping consumers, funding does not appear out of thin air.
Hoffman said that the program offers a relief, but there is a catch at the end. For the sake of his clients, he hopes this debt is not taxable in 25 years, but he would rather err on the safe side by setting aside funds for the IRS.
Hoffman hears stories constantly: about 35-year-olds still living at home, about couples that cannot afford to buy their own home. The stories are full of economic hardship and show why the economy is stunted. Young professionals cannot grow. Couples cannot expand.
But even with this weight on consumers, he understands why the tax is necessary for the government. The news is splayed with coverage and fear-laced stories about the fiscal cliff and the debt ceiling.
“We are in a sticky situation,” he said.
Although it would help borrowers if the additional tax was absolved, it would not help the U.S. government get out of its own looming debt crisis any faster.
Even beyond the government, higher education is safer due to the recent payment programs. Few borrowers care to think about how their universities fair in this economic situation, but IBR can severely impact the future of higher education.
IBR is protecting the funding for schools. If students cannot repay their student loans and default on the loans, many schools would lose their access to Title IV federal funding. Hoffman said the university aspect is an overlooked aspect of IBR.
“The program allows borrowers to continue borrowing and schools stay in business,” Hoffman said.
Need, Want and Push
In the end, poor planning has caused the headache of dealing with mounting student loan debt.
Hoffman said a lot of his clients state, “‘If I only knew what I was doing when I was going to school.’”
Although student debt is a mounting issue for the country, Hoffman does not put the blame on the amount of debt, but rather on the reason for why it accumulated in the first place.
“There is a need, want and push to get to school,” he said.
Hoffman said that IBR solves the problem of repayment but it does not get at the main issue.
“The real problem is how they got the debt in the first place, not that they have the debt,” he said. “This program, instead of treating the actual problem, is just treating the symptom. Instead of having a vaccine to pay for tuition and debt…it is like a pharmaceutical company that makes a pill that is letting you live longer with the disease.”