Forgiveness occurs when you reach the maximum repayment period under an income-driven repayment plan (IDR), like Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE). When you reach the maximum number of payments under a respective IDR, any remaining unpaid interest or principal amount is forgiven. Currently, forgiven amounts are treated as “canceled debt” by the IRS (https://www.irs.gov/taxtopics/tc431.html). Generally, canceled debt is treated as ordinary income, thus taxed at your marginal income tax rate during the tax year the debt is forgiven.
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IDR Aspects
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IBR 2009
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PAYE
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IBR 2014
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REPAYE
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Maximum repayment period (in years)
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25
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20
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20
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25
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Maximum repayment period (in months)
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300
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240
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240
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300
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Forgiveness taxable
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Yes
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With high starting student loan repayment balances and maximum repayment periods of 20 and 25 years, it is quite possible for the forgiven amount to be higher than your starting balance due to unpaid interest. You can test various repayment scenarios using the VIN Foundation Student Loan Repayment Simulator.
How do we account for student loan forgiveness when it does occur? First, no one can tell you what the income tax rates will be when your taxable loan forgiveness occurs and we won't see a large group of borrowers hit student loan forgiveness until 2032. However, we can make some reasonable assumptions based on historic and current federal and state income tax rates. Currently, the highest 2018 federal income tax rate is 37% and begins at incomes over $500,000 for single filers and $600,000 for married joint filers. Keep in mind that tax brackets are also adjusted each year for inflation. For example, in 1997 (21 years ago), the top federal tax bracket started at incomes over $271,050 per year for single filers and was taxed at a rate of 39.6% (higher than the top marginal tax rate today).
For illustration, let’s say you have a total taxable income plus forgiven balance of $500,000 in 20 years under PAYE and the federal tax rates and brackets are the same as they are now. When forgiveness occurs, we'll assume you are married and plan to file your taxes jointly.
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Tax bracket for Married Joint Filers
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Calculation
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Tax amount
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First $19,050 is taxed at 10%
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0.10*$19,050
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$1,905
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Amounts between $19,051 and $77,400 taxed at 12%
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0.12*($77,400-19,051)
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$7,002
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Amounts between $77,401 and $165,000 taxed at 22%
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0.22*($165,000-77,401)
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$19,272
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Amounts between $165,001 and $315,000 taxed at 24%
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0.24*($315,00-165,001)
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$36,000
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Amounts between $315,001 and $400,000 taxed at 32%
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0.32*($400,000-315,001)
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$28,000
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Amounts between $400,001 and $600,000 taxed at 35%
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0.35*($500,000-400,001)
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$35,000
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Amounts over $600,001 taxed at 37.0%
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0.37*($0)
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$0
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Total Tax Amount
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Sum of tax amounts
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$127,179
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Effective Tax Rate
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$127,179/500,000
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25.4%
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Marginal Tax Rate
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Highest tax rate
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35.0%
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Under this example scenario, ideally, you would plan to have enough saved to cover the tax liability of $127,179. If you use a conservative estimate of $130,000 to have on hand for the tax due, you could save $130,000/240 months = $542 per month to cover the tax liability.
Alternatively, you could save for the tax liability using investments (money market, certificate of deposit, equities, bonds, annuities, life insurance, etc, or a combination thereof) in an effort to earn interest on your forgiveness savings. For example, if you were to receive at least a 3% return on your forgiveness savings, you could reduce your $542/month savings plan to $395/month in order to have $130,000 on hand to cover your forgiveness tax liability from the example above
Estimating your potential forgiveness amounts and planning for a possible tax liability can reduce your overall loan repayment costs substantially.
Let's say you borrowed $220,000 in federal student loans to get to and through veterinary school and accumulate about $30,000 of unpaid interest during school. If we run a simulation of your repayment using a starting income of $80,000/year increasing by 3% per year and assume a family size of 1 for the duration of repayment using PAYE, your total repayment costs might be $252,988 assuming a 30% tax on amounts forgiven and a forgiveness savings plan return of 3% per year.
Effective Annual Interest Rate
If you’ve paid $252,988 in total under PAYE including the forgiven amounts, that means you have paid $32,988 in interest over 20 years (amounts above your starting repayment balance, $252,988 - $220,000 = $32,988). The proportion of your total interest above what you borrowed = $32,988/$220,000 = 0.15. If we annualize that by the 20 years you paid that loan, your “effective annual interest rate” equals 0.15/20 * 100 = 0.75% per year.
The effective annual interest rate calculation will help you compare repayment under an IDR vs. a private consolidation loan and help you understand how much it is costing you to pay your student loans back under income-driven repayment. Oftentimes private consolidation loans will look enticing because of the seemingly lower variable or fixed interest rate that you may qualify for based on your credit history. However, if you know how the IDR plans and forgiveness affect your repayment costs, you can better assess whether or not that private loan refinance offer will save you money or if it actually does make sense to pay more than your minimum monthly income-driven payment requires.