One of the programs that many students take advantage of upon graduating from college is income based repayment. There are a handful of different income based repayment programs, with the first program starting in 1994.
The idea behind income based repayment is to allow graduates to apply to make more manageable payments according to their income levels. Student loan payments are based on a 10-year repayment. However, with income based repayment, your monthly payment is capped at a specific percentage (15% is common) if you meet certain requirements. At the end of 25 years, if you haven’t paid off the entire balance, the remaining balance is forgiven.
For many students who are struggling to find work right now, and who are burdened with student loans, income based repayment can be a big help. However, some students might end up with a large tax bill at the end of the 25 year repayment period.
Forgiven Liabilities Are Taxed as Income
The biggest reason that some students might be in for a rude awakening is the fact that forgiven student loans are taxed as income. That means that when you get to the end of your plan, you could see a big tax bill.
For some students, it might not be a big deal. They might only have a couple thousand left that is forgiven — barely enough to bump someone into another tax bracket. Other students might not be so fortunate. Lawyers and doctors, who traditionally have large amounts of student loans, might go on income based repayment and still have large balances forgiven after 25 years. This can mean a tax bill in the hundreds of thousands of dollars.
Avoiding a Big Tax Bill at the End of 25 Years
One way to avoid the big tax bill is to pay off the loan within the 25 year period. The hope when you start on income based repayment is that you will eventually make enough money that you will make larger payments as your income rises. The hope is that you will see income increases over the course of your career.
On top of that, it’s possible to pay off your student loans early when you have the means. It might not always feel desirable to pay off your student loans faster, but if you have a higher interest rate (in the 5% to 6% range), it might be worth it to tackle your student loan when you have a higher income and your other liabilities are taken care of. Paying of the loan before the 25 years are up and it is forgiven can save you money on taxes.
Another option is to refinance. There are companies out there that refinance student loans to lower rates. You might have a 6% rate on your federal student loan, but qualify to refinance privately at a 3% rate. However, you need to be careful because there are protections with a federal loan. Once you refinance privately, you lose those protections.
Carefully think about your situation and your options. It can make sense to go with income based repayment now, but you need to plan ahead to avoid being stuck with a large tax bill later.