Thursday, June 25, 2015

Student Loan "Tax Bomb" - IBR, PSLF, PAYE & REPAYE

Student loans are confusing. They are particularly confusing for law graduates when nearly 85% of law school students graduate with $100,000 or more in debt.

We started with Income Based Repayment (IBR) that allows borrowers to pay back their student loans based on their income. Then we moved to IBR coupled with Public Service Loan Forgiveness (PSLF) for borrowers who took out loans between 2007 and 2011 and work at a 501(c)(3). This allows graduates to pay based on their income and after 10 years of repayment while working at a non-profit, the rest of the debt is forgiven without a tax burden.

For those not working under PSLF but utilizing IBR, the terms were adjusted to allow borrowers to limit repayment to 15% of their discretionary income and have any remaining balance forgiven after 25 years of repayment with a tax burden on the amount forgiven.

Then in 2012, the Pay As You Earn (PAYE) program was created so that graduates could limit their federal loan payments to 10% of their discretionary income and  have any remaining balance forgiven after 20 years with a tax burden on the amount forgiven.

With both IBR and PAYE, the amount forgiven after 20 or 25 years is treated as taxable income, which one law professor calls a "tax bomb." Thousands of recent law-school graduates have taken advantage of these programs aimed at easing student-debt burdens.

The plans require federal student-loan borrowers to pay back as little as 10%-15% of their discretionary income each month over 20 to 25 years. After that period, any remaining balance is forgiven. As attractive as the terms may be, some law-school graduates enrolled in the programs could be facing what one law professor dubs a “tax bomb” down the road. Specifically, it’s set to go off in 2032, the first year when the loans qualify for debt forgiveness. At that point, the forgiven debt turns into “cancellation of debt” income under the tax code, taxed as ordinary income, says Southern Methodist University law professor Gregory S. Crespi.

For an IBR or PAYE law graduate enrollee with a $200,000 or larger unpaid debt at the time of their debt forgiveness this may well mean a combined federal and state income tax bill on this additional attributed income of at least $50,000 up to perhaps $100,000 or more, and an enrollee with $300,000 or more of forgiven debt may owe additional income taxes in the neighborhood of $125,000 or even more!

Now there is a revised Pay As You Earn (REPAYE) program expected to launch in December 2015 that will greatly diminish the impact of the "tax bomb." REPAYE is a new income-based repayment program that is available to all federal direct loan borrowers regardless of when they took out their loans. It allows borrowers to cap monthly payments at 10 % of their discretionary income and have any remaining debt forgiven after 20 or 25 years without the "tax bomb." Under the proposed REPAYE program, however, spousal earnings are now included in the calculation of discretionary income.

For those of you currently taking advantage of IBR or PAYE, you may want to consider enrolling in REPAYE when it becomes available to stop the "tax bomb" from ticking.

For those of you currently taking advantage of IBR with PSLF, you may want to wait and see how PSLF works with REPAYE before taking the plunge.

More to come...

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