Using Tax Planning with Student Loans

Student Loan Relief and Tax Consequences

President Biden announced on Wednesday, August 24, 2022, that his administration would cancel up to $20,000 in student loan debt for eligible Americans. The student loan debt question has been in the forefront of the minds of the 45 million Americans who combined owe $1.6 trillion in debt. With the topic of student loan debt on everyone’s minds, there are many questions about the taxability of forgiveness, how taxable income plays a role in income driven repayment plans, and more. We’ll walk you through all this and more!

Loan Repayment Plans

Students have several options to repay their student loans. There are four “standard” repayment plans: standard repayment, which is equal monthly payments over 10 years (120 payments); graduated repayments, which is lower monthly payments increasing yearly over 10 years (120 payments); extended repayment, which is equal monthly payments over 25 years (300 payments; or extended graduated repayment, which is lower monthly payments increasing yearly over 25 years (300 payments.)

For students who cannot afford the above options, there are also what are called Income-Driven Repayment (IDR) plans. There are four of these as well: Pay-as-You-Earn (PAYE) and Revised Pay-as-You-Earn (REPAYE), which have monthly payments equal to 10% of your discretionary income but take spousal income into account differently; Income Based Repayment (IBR), which has monthly payments equal to 10% of your discretionary income but has more requirements than the REPAY or PAYE plans; or Income Contingent Repayment (ICR), which has monthly payments equal to 20% of your discretionary income.

How Are Income-Driven Repayment Plans Calculated?

Slightly more than 30% of all individuals who have student loans are on Income-Driven Repayment (IDR) plans. For those who are on these plans, the method of calculating the monthly repayment amount can seem extremely opaque. So let’s demystify the whole process!

Calculating an IDR payment amount begins with the individual’s Adjusted Gross Income, or AGI. Your AGI is calculated by beginning with all your income, and then subtracting out certain deductions. Some deductions, such as retirement contributions, certain medical contributions and expenses, and others, are taken into consideration first. From there, you may be able to deduct other things, such as student loan interest, depending on income thresholds. (If you have your tax return, your AGI is listed on line 11.) If you are married filing jointly, you will start with your joint AGI. If you are married filing separately, some plans will let you exclude your spouse’s income.

Once you have your AGI, you have the starting place for your monthly repayment amount. From your AGI, you then subtract an amount equal to 150% of the federal poverty line for your family size. Interestingly, even if you are filing as married filing separately, you can claim a family size that includes your spouse. So if you are married, filing as married filing separately, and have no children, your family size will still be two.

The amount you are left with after you have taken all deductions into consideration and subtracted the allowance for your family size is considered your “discretionary income.” This is what your payments are truly based on. Depending on which plan you choose, your total annual repayment amount will be equal to 10, 15, or 20% of your “discretionary income.” This means your monthly payments will be equal to 1/12 of that amount. The plan announced by President Biden will allow undergraduate loan amounts to be capped at only 5% of the “discretionary income” amount.

Using Tax Planning to Reduce Your Payments

If you want to reduce your student loan payments, the best place to start is by reducing your AGI. Your starting point should be maximizing contributions to a retirement account – this typically is simply excluded from your gross income, which in turns reduces your income threshold for many other deductions that have income limitations. 

Your tax advisor should be able to analyze if you would benefit from a change in filing status if you are married. Some repayment plans allow you to exclude your spouse’s income from the repayment calculation. If you have children and are married, your tax advisor may also analyze if you are claiming as many deductions as you are entitled to, and that the right spouse is claiming the children.

The Student Loan Forgiveness “Tax Bomb”

Many people are looking to simply reduce their payments now and not looking to the future. Most probably look at the word “forgiveness” and think that it is truly what it is – your debt is forgiven and forgotten. However, reducing your income driven repayment amounts can lead to a bigger tax consequence down the road.

It may surprise you to learn that for most people on the IDR plans, any forgiven loan amount will be considered income in the year it is forgiven! This means if you have $30,000 in loans forgiven, your taxable income will be $30,000 more in that year. For those who successfully complete the Public Service Loan Forgiveness Program (“PSLF”), these amounts are not included in net income. Unfortunately, so far only 2.16% of eligible borrowers have had their loans actually forgiven. For most people, the amount will be included in their income.

However, this is where more tax planning can come in handy. Clever tax planning in the year you expect your loans to be forgiven can help you reduce your taxable income before you are hit with the “tax bomb.” You should work with your tax advisor to determine the best plan of attack for student loans and the potential tax bill.

Student Loan Relief

Things are not all doom and gloom with student debt. There are some current provisions that taxpayers may be able to take advantage of until 2026. For instance, employers can currently reimburse their employees for student loan repayments, up to $5,250 a year, without that amount being included in their taxable income. Additionally, student loans forgiven through the IDR plans will not be included in your taxable income until 2026. This is a temporary provision provided by the American Rescue Plan. Time will tell if it is popular enough to become permanent or not. 

The new relief plan released by President Biden has few surprises in it. Under the proposal, individuals earning up to $125,000 and households earning up to $250,000 will be able to have up to $10,000 in student loans forgiven. If you have student loans and received a pell grant, the amount that will be forgiven is increased to $20,000. Students who are repaying only undergraduate loans will have their payments capped at 5% of their discretionary income. The plan also seems to propose covering interest payments for undergraduate borrowers who continue to make timely payments, and increasing the federal poverty line multiplier from 150% to 225%.

There are still many outstanding questions about this plan. It is not clear, for instance, if the income limitation will be based on gross income or AGI. It is also unclear if a household making $250,000 with two borrowers will be capped at the $10,000 amount or if each borrower will be eligible. We also don’t yet know how the $10,000-$20,000 in student debt relief will end up being taxed. Due to the changes under the American Rescue Plan, it should be excluded from ordinary income – after all, it’s not much relief if you end up being taxed on it! 

While the proposed rules and plan is still largely theoretical, there is still ample opportunity to plan with student loans and with education. A good offense is often the best defense when it comes to planning for education costs. Make sure you take full advantage of education credits and deductions while you are still in school, and work with your advisor to plan out your tax future as well as your educational one!