Saturday, December 15, 2012
The loan forgiveness portion of the income based repayment ("IBR") program means that participating law grads may get hit with a big tax bill at the end of their repayment schedule since debt forgiveness is deemed "income" by the IRS. And what could turn out to a very large tax bill will have to paid immediately since, as the NYT coyly points out, the IRS doesn't have an income based repayment program for taxes owed. From today's New York Times:
Those breathing a sigh of relief that their student loan payments are now in line with their income may want to re-examine the rules that set the payment in the first place. There could be a tax time bomb looming, slowly ticking away. And defusing it is not a big part of the policy discussion in Washington at the moment.
This potential tax bill is a byproduct of federal efforts, including the newly expanded income-based repayment program, that allow you to limit the monthly payments on most federal loans to what you can afford to pay. There’s a formula that uses your income to determine your payment. Then, the federal government forgives any remaining balance, usually after 10 to 25 years.
The catch comes with the forgiveness, since you generally have to pay income taxes on any forgiven debt (unless you were in a program for teachers or worked in a public service job, in which case the taxes go away). For many people, especially those who finished graduate or professional school with six figures of debt, the tax bill could be well into the five figures. And when it comes, you are supposed to pay in full, immediately.
Figuring out just how many people will be in this situation — and just how high the tax bill could be — is a tough task, and not many experts have tried it.
. . . .
Trying to pinpoint the scope of the looming tax issue starts to get more complicated pretty quickly. Not all eligible students will sign up for income-based repayment, since some will not hear about it, will ignore it when they do, will assume or be told (incorrectly) that they can’t qualify or will worry that there is some kind of catch. For those who sign up, it’s awfully hard to predict how many will eventually have some debt forgiven a couple of decades from now.
But Jason Delisle, who has written extensively about the income-linked repayment programs as director of the federal education budget project at the New America Foundation, points to an Office of Management and Budget effort that took a stab at it. The O.M.B. assumed that 400,000 borrowers from 2012 through 2021, each with a beginning average loan balance of about $39,500, would each eventually receive loan forgiveness of about $41,000. Yes, you read that right. The forgiven debt will be more than the original balance, albeit many years later.
At $41,000 of loan forgiveness, the federal tax bill could easily be over $10,000 depending on your tax bracket. There are also state income taxes to contend with, depending on where you live.
But the numbers can go much higher. Stephanie Day earned her bachelor’s degree in her 40s after a divorce, intending to enter the field of social work. She finished in the depths of the recession and could not find work, so she returned to school to get a master’s in psychology to bolster her credentials.
Even then, the jobs available near her home in Seattle were slim, so she moved to a town on the border of New Mexico and Texas for a position there. One home invasion and 12 months of misery at being apart from her children later, she’s now back in Seattle and paying just $30 each month on her $80,000 or so in debt via the income-based repayment plan.
Ms. Day has run the numbers and can foresee a situation where the government will forgive more than $100,000 of her debt, given that her unpaid balance keeps growing thanks to the low payments.
. . . .
“Let’s say your debt has grown to $180,000 over 20 years, and by that point, you’re making $120,000,” he said. “If $180,000 is being forgiven, then you’re looking at paying taxes on $300,000 in total income in one year. At that point, you’re over the $250,000 income category, my friend.”
. . . .[W]orries about a tax bill a couple of decades from now shouldn’t scare you away from signing up for the income-based repayment plan if you need it. But however the numbers turn out, anyone enrolled in the plan ought to be thinking hard about salting away some money, somewhere, for the eventual tax bill.
After all, no matter how high the bill, there are severe penalties for not paying it right away. The Internal Revenue Service, alas, does not have an income-based repayment program.
You can read the full article here.