Student Loan Crisis
If you have the opportunity to pay off your student loan debt, congratulations. It’s a great relief, and another step toward achieving more financial freedom. The process can take years — even decades.
Now, let’s talk about graduates that are enrolled in an income-driven repayment plan. Did you know that their student loan debt may be forgiven after 20 or 25 years? If it sounds too good to be true, you’re right. Loan forgiveness recipients are now hearing more about tax bombs. After loan forgiveness, college graduates are being notified that they now owe more money — to the IRS. They must pay taxes on the amount that was forgiven.
Tax bombs are most common among people with income-driven repayment plans. It can be a big surprise and another financial burden if you are unprepared to make the payment. There is also a chance that your tax bill will be due immediately.
Understanding income-driven repayment plans
If you are enrolled in an income-driven repayment plan, take notes. These plans were designed to last about 20 to 25 years, planning for a payoff by the end of this term. If a balance remains, the remaining cost is forgiven. However, the forgiven amount is now taxed as income.
Avoiding a tax bomb
If your loans are forgiven while enrolled in a different federal student loan program, the remaining balance will most likely be tax-exempt. This means you won’t have to deal with a tax bomb. There are also other scenarios for exemption:
- Goodbye, Perkins loans
If you qualified for having your Perkins loan canceled, you can rest easy about a tax bomb. Eligibility includes working or volunteering in a way that meets the criteria for cancellation.
- You have a different reason for cancellation
If you were enrolled at a school but defrauded by them, your loans can be resolved without the worry of a tax bomb. Another example is if your school closed while you were enrolled.
- Someone dies or has a permanent disability
In the unfortunate event of death or someone becoming permanently disabled, the estate will not be taxed.
Various states offer forgiveness programs. However, it’s best to do your research before assuming that you will be tax-free after loan forgiveness.
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Calculating the costs
If you are anticipating a tax bomb, consider these two things: the amount of your loan that will be forgiven and your current financial situation. Keep in mind that a forgiven student loan may also push you into a higher tax bracket; it is additional taxable income. This could bring an even larger tax headache.
Loan forgiveness can also affect your state taxes. It’s always best to check with a tax professional. While doing your research, you will learn that some states don’t have income taxes. Some states also don’t tax forgiven student loan amounts that occurred during the income-driven repayment plan.
Planning for the tax bomb
If you don’t think you will be able to pay off your income-driven payment plan within 20-25 years, start saving. You may have to deal with a tax bomb. Here are two tips:
⦁ Estimate your bill
Did you know that there is a repayment estimator? Visit studentaid.gov to learn more. While tax brackets can change, it is still helpful to begin with a plan. Using the resources from the Bureau of Labor Statistics, gain more insight into your earning potential. Then, you can see how much you may owe.
⦁ Save, save, save
If you know that you will not be able to pay off your loan within the allotted time, it is best to not pay extra on your monthly payments. Instead, set it aside for a potential tax bomb. You can start with $50 each month. You will be amazed at how a small amount grows over time.
Paying for the tax bomb
If the tax bomb payment is too high or unmanageable, there are options. For many people, this large amount of money is not sitting in their bank accounts. Consider all of the other financial goals such as buying a home or saving for retirement.
How should you respond? Learn more about the payment plan agreement through the IRS. Keep in mind that these plans charge fees and interest. Interest rates change every quarter. Depending on the situation, the IRS may also recognize that your liabilities are greater than your assets. This means that you may have a difficult time paying the amount. The IRS may either exclude some of your forgiven balance from your income — or, even better, the full amount.
If you are enrolled in an income-driven repayment plan, start asking questions early. Get connected with a tax professional to see if you will need to prepare for a tax bomb. Knowing where you stand with your loan forgiveness options is the first step to success.
How did we get here and how bad is it?
In a generation, the financing of college education has shifted from being largely state and federal tax funded to being funded by a combination of federal and private loans.
As state and federal support continued to recede, accelerated by the Recession of 2008, loans became the funding mechanism for students. The issue has now reached a critical point as demonstrated by the following benchmarks:
The outstanding student loan debt balance has tripled over the last decade and shows no sign of retreating.
Student loan debt is now $1.6 TRILLION and is projected to reach $2 TRILLION by 2022
There are now 44.7 MILLION student loan debtors, 40% of adults in American between the ages of 18 to 30 have student loan debt. An astounding 2.5 million student loan debtors have debt in excess of $100,000 and 101 student loan debtors now have student loan debt in excess of $1 million.
In 2018, the student loan program returned a gain to the federal government, but in 2019 a tipping point in the program passed, and the program began running at a deficit. This deficit is projected to increase as 40% of student loans taken out in 2004 are expected to default by 2024 and only half of loans from 1995-1996 were paid off 20 years later; the half not paid off still owed an average of $10,000, about half of the original loan amount. The average student loan balance today is $37,172. (Student Loan Planner.com, July 18, 2020)
The sheer size of the student loan debt has a significant impact on the economy. Student loans are almost 11% of all installment debt, higher than auto loans and credit card debt; only exceeded by home mortgage debt. Auto loans in default by more than three months is higher now that at the height of the 2008 financial crisis. Auto loans are considered the “first debt” payment of choice, a bellwether indicator. Students are hard pressed to make their loan payments as demonstrated by the US government garnishing more than $600 million from student borrower’s paychecks in 2017.
Taking money out of retirement funds early not only reduces the ability of those funds to compound, but make the total amount of funds available in retirement smaller. The earlier funds are withdrawn, the bigger the impact.
The following younger generation cohorts took money early from their 401K savings to pay (in part) for student loans:
Gen Y 22% (in part for student loans)
Gen X 8% (% just for student loans)
Gen Z 26% (in part for student loans)
The student loan crisis has had incredible impact on the social and economic development of its loan holders. One in eight divorces are reported as directly related to student loans. Student loans are cited as causes for not purchasing new autos, homes, getting married or starting families. Between 2005 and 2014, an estimated 400,000 student loan borrowers did not buy homes. Within six years of taking on student debt, half of all debtors leave rural areas, exacerbating the rural exodus.
The multibillion-dollar scholarship program in America would seem to take some of the burden of costs of college off of the student. But scholarships do not reduce student debt for most students, they reduce grant-in-aid money given to the student and wind up benefiting the educational institution. The student’s cost to attend college remains the same. And, to add insult to injury, scholarship awards are treated as federal taxable income. For all the effort students may put into winning scholarships, the net result for most is that their college education costs are unchanged, the college benefits by reducing their grant-in-aid support and the student incurs a tax liability.
Students with federal loans are eligible for a reduced loan payment program based on their disposable income. Students fill out an annual form with their financial information and their monthly loan payment is computed to be 10% of their disposable income. This makes the loan payment more affordable, BUT because the payment often does not cover the total of the loan principal payment and interest payment, their loan goes into reverse amortization: in other words, their loan balance grows each month instead of shrinking.
Many of these students try to enroll in the loan forgiveness program; after ten years of working for a nonprofit organization, their loan balance is forgiven. Two problems with this solution are: one, under the current situation, successfully enrolling in the loan forgiveness program is exceedingly difficult; and two, when the loan is forgiven, the amount of that is forgiven becomes federally taxable income for the student. So, the student is left with a large unfunded tax obligation.
The impact on older Americans is stunning, in 2008 lenders began requiring parents (or grandparents) to cosign for their child’s (or grandchild’s) loans. This happened because the credit ability of students was insufficient to cover the increased costs of tuition, books, fees and housing.
Consequently, persons over 60 years of age now owe $89.9 BILLION owed by 3.6 million persons 60 years old and older. This caused a 161% increase in student loan debt held by those over age 60 (from 2010-2017). The average loan balance in 2017 for those over 60: $33,800. In what seems to be unthinkable, 114,000 persons in 2015 had their Social Security payments garnished to repay student loans.