The more I look at the student loans system, the more perverse it seems. Although I have covered aspects of it off and on over the years I have never looked at it from the point of view of a tax planner. As I dove into that over the last few weeks, I have become more and more outraged, but I always remember Reilly’s First Law of Tax Planning- It is what it is. Deal with it.
An Example
Taylor has just completed a MFA. Never mind in what. What difference would that make? Taylor’s parents, Robin and Terry, are reasonably successful professionals. Now divorced they each own homes and have retirement accounts in the high six low seven figure range, but not much else in the way of other assets. They are in their mid-sixties and do not have pensions.
Robin and Terry paid for almost all of Taylor’s undergrad and considered that a successful launch. Robin thought around ten grand in student debt would be good for Taylor’s character. They have Taylor’s sibling Ryan to think about.
Robin is a financial professional and would offer Taylor all sorts of practical advice, but you know how that goes. Taylor is in a committed long term relationship with Bobby, marriage being considered, and just recently baby Brooklyn has been added to the mix. This motivated Taylor to open up to Robin about the finances.
Robin was shocked to find that Taylor had borrowed to get the MFA, a credential that the hard-nosed Robin thinks is not worth the powder to blow it away. Robin loves literature every bit as much as Taylor does, but found other things to do to feed the family.
Taylor’s student direct loan balance is at $70,000 and based on when Taylor drew on the loans, the interest rate is around 6%. Robin asked me for some planning ideas. And rather than blow him off, I started digging.
Some Perspective
If Taylor was going into public accounting, I probably wouldn’t worry so much. The standard payment payoff plan for a direct student loan is 10 years. That works out to $777 per month which is brutal for a staff accountant making $50,000 – $60,000 per year, but Taylor wouldn’t be a staff accountant forever. It might be $70,000 – $80,000 in three years and over $100,000 after five or six. That might be a little on the optimistic side, but I see even larger numbers being cited in some places.
Taylor on the other hand would be doing quite well to find a job that pays $40,000 and will be lucky if income keeps up with inflation.
Refinance?
One of Robin’s ideas was to come up with thirty-five grand each and just pay the thing off, maybe charging Taylor 3% interest only with principal paid whenever possibly squaring up with Ryan in the wills. Terry’s financial adviser vetoed that plan on a number of grounds but suggested refinancing.
I spoke with Vince Passione of LendKey. LendKey’s main business is providing platforms for credit unions to be able to refinance student loans. We jawed a bit about the system.
When I asked him why the interest seemed so high, he told me he thought the idea was that the money the program made on the doctors and engineers and CPAs would offset the defaults by the MFAs, but there is a flaw in the plan in that the doctors et al. can refinance.
The rate is the high yield of the 10-year Treasury notes auctioned before June 1 plus 2.05% for undergraduates and 3.6% for graduate students for all loans first disbursed in the following year July 1 to June 30.
More significantly for these purposes, LendKey has a website that will let you get simultaneous quotes from a large number of credit unions. I put Taylor’s information in and it came back with 3.39% to 5.5% depending on the term.
That could be something worth doing but it actually is not that helpful. The low rate, for a shorter term, gets the payment a bit below $700 per month and saves about $11,000 over ten years, but it is not enough to make the payments affordable.
Other options Taylor has that are full pay are a graduated repayments and the Extended Repayment Plan which can be up to 25 years. That would be $451 per month, which might be manageable. But 25 years?
And most importantly refinancing eliminates some other options that at least on their face are attractive.
Alphabet Soup
If Taylor isn’t going to be risking default, the thing to consider is one of the income-driven repayment plans. You have REPAYE, PAYE, IBR, and ICR. There is a table on pages 9 and 10 of this guide that outlines the options.
On the Department of Education’s Federal Student Aid website, there is a Loan Simulator. I did a rough estimate of Taylor’s situation with a $40,000 salary with 2% raises. You can see the results here. With a login, you can have the debtors actual accounts loaded in.
Just based on the simulator, which should not be considered a be-all-end-all, Taylor’s best deal would be either IBR or PAYE. Rather than $777 per month for ten years or $451 per month for 25 years, Taylor would start out paying $174 per month working up to $235 per month. In 2040 the balance of $105,344 would be forgiven (Note the payments under the program don’t even cover the interest).
Who’s Afraid Of The Big Bad Debt Discharge?
Most of the discussion I see alludes to the fact that under current law that $105, 344 could be taxable. That is cited as something that scares people off. Well, of course, an unrealistic solution would be for Taylor to put aside a couple of hundred bucks a month in anticipation of that 2040 tax bill. That is not going to happen, but it would have Taylor way ahead.
But the other thing you should do with a problem like that is plan for it, because, under Section 108, debt discharge income is only taxable to the extent that it makes you solvent. So Taylor will only be taxed on $105,344 if Taylor has assets, reachable by creditors, that much or more.
Among the assets that are not reachable by creditors would be home equity that is protected by a homestead exemption. The IRS currently takes the position, supported by some decisions, that retirement accounts do count, but as an initial filing position, Taylor could think otherwise.
But what about Taylor’s inheritance? That is what planning is all about. If IBR is the plan Taylor adopts Robin and Terry will be leaving their wealth to a spray trust or a similar vehicle.
The Downsides Of Income-Driven Repayment
A big downside of the various IDR plans is that interest is being capitalized at a pretty stiff rate so that if Taylor does better in the earnings department, more will end up being paid (This is a place where the fine points of the four alternatives come in, but I don’t intend to go that deep in this piece). And it is kind of nerve-wracking to be making payments on a loan with a balance that keeps going up.
A much bigger concern is how real the forgiveness promise is. I interviewed Victoria Haneman, Frank J. Kellegher Professor of Trusts & Estates at the Creighton University School of Law.
An Expert
Professor Haneman, arguably a first wave Millennial still has student debt outstanding. She has written on both the policy and practical issues:
Intergenerational Equity, Student Loan Debt, and Taxing Rich Dead People
Marriage, Millenials, and Massive Student Loan Debt
The Collision of Student Loan Debt and Joint Marital Taxation (I reviewed that article here)
Among other things she teaches estate and gift taxes, so one of the things I asked her was whether the type of thorough planning that goes into estate and gift taxes is being done by anybody for student loans.
She doesn’t know of anybody doing it. Of course on an individual level, the stakes are too small. I mean what is fifty grand one way or another over twenty years to an estate planner? In the aggregate, it is a different story. IRS collected $20 billion in estate taxes in 2017. Student loan debt is at $1.6 trillion.
The Biggest Problem
As I was bouncing ideas off Professor Haneman, one of the main sources of concern is that the Department of Education does not issue enough reliable guidance.
Since all the income-driven repayment plans key off Adjusted Gross Income (AGI) for income tax purposes, it occurred to me that one way to beat the system would be to go abroad to work abroad. That knocks $105,900 out of your AGI thanks to the foreign earned income exclusion. I did think of it myself, but it seems Rebecca Safier was ahead of me. But I am not absolutely certain that the idea works.
In the regulations I found:
“If the borrower’s AGI is not available, or if the Secretary believes that the borrower’s reported AGI does not reasonably reflect the borrower’s current income, the borrower must provide other documentation to verify income.”
What happens to your IDR payments if you are audited by the IRS and your AGI is adjusted?
Student borrowers communicate with personnel working for one of the servicing companies. There are currently eleven of them. They can’t rely on anything they are told on the phone. They have nothing that tells them for sure that they are advancing the twenty or twenty-five-year clock that leads to the forgiveness light at the end of the tunnel.
The First Round Of Forgiveness
Nobody has served the twenty-year sentence yet, so we don’t really know how that is going to go. The first round of forgiveness was for people who were in public service jobs which was a ten-year clock. The outcome there was disastrous.
According to this story by Forbes contributor Zack Friedman, out of 136,473 applications for forgiveness, only 1,561 were approved. Those kind of numbers make me think that DOE set things up so that it was easier to reject an application than accept it and it is not uncommon for people to be considered to be doing a good job, by how quickly they get things off their desk.
Mr. Friedman has a recent piece giving information on how unforgiving the public service forgiveness program turned out to be.
It May Be Different
When Taylor is coming up on forgiveness in 2040, the ball is actually in DOE’s court. According to the regulations Taylor does not have to apply
When the Secretary determines that a borrower has satisfied the loan forgiveness requirements under paragraph (a)(6) of this section on an eligible loan, the Secretary cancels the outstanding balance and accrued interest on that loan. No later than six months prior to the anticipated date that the borrower will meet the forgiveness requirements, the Secretary sends the borrower a written notice …
The Secretary determines when a borrower has met the loan forgiveness requirements in paragraph (a)(6) of this section and does not require the borrower to submit a request for loan forgiveness.
The first wave of forgiveness will be in 2034, so hopefully, the kinks will be worked out when it is Taylor’s turn.
Some Perverse Planning Points
The most annoying part of this whole scenario is that it punishes prosocial behavior. Robin and Terry grew up in relatively modest circumstances. They both received scholarships and as they prospered donated much more to their colleges than they had received. So of course they were happy that they could pay full freight for Taylor.
Taylor was very appreciative that there was not a load of student debt accumulating during the undergrad years when comparing notes with friends. As it turns out had Taylor done the maximum possible borrowing rather than the character-building ten grand, Taylor’s prospective payment obligations under the Income-Driven Plan would be exactly the same even though the total debt might be $170,000 rather than $70,000.
There is also the educational malpractice of encouraging young people to borrow to obtain credentials that won’t finance repayment. I have a pretty good liberal arts background, well for a CPA anyway. Most of it comes from reading books, which is not a very expensive activity.
Robin for all the tough love you are your own attitude has been doing things to help Taylor get established and financially responsible. When Brooklyn came along Robin paid the premium on Taylor’s life insurance policy. Robin opened up a ROTH IRA based on Taylor’s meager Uber driving earnings one year.
So of course, Robin was immediately thinking of a 529 plan for Brooklyn but now wonders what the point is. The family would be ahead a hundred grand if Taylor had borrowed more.
Another Opinion
I checked in with Alan Collinge of Student Loan Justice. He and I have been in touch about the issue since the Occupy Wall Street days. Alan is not high on the various income-driven plans.
They are all failing. Just as less than 1% of the people trying to get Public Service Loan Forgiveness were disqualified for one reason or another, so too will the vast majority of people in any of the Income-driven repayment programs be kicked to the curb, and left owing far more than had they never tried in the first place.
Regardless, I think it clearly beats going into default.
Bottom Line
The prospect of a tax problem down the line should not deter people like Taylor from entering into one of the income-driven repayment plans. There is no question that it is better than defaulting. One thing that is clear in the regulations is that payments made while in default do not advance the twenty year clock.
Some of the policy observations that Professor Haneman makes in her article are really worth considering, but we will save that for another piece.
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