Those breathing a sigh of relief that their student loan payments are now in line with their income may want to reexamine 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 specialists have tried it.
Sorting it all out begins with the repayment programs themselves. Some people signed up for income-contingent payments back in the 1990s. The income-based program came along more recently, and the Obama administration then tweaked it to make it more generous by shortening repayment periods and adjusting the formula used in figuring out the monthly bill.
As of Oct. 31, about 2 million people had applied for income-based repayment, according to Education Department figures. About 1.3 million had low enough income and high enough debt payments under standard repayment plans to qualify for reduced payment under the terms of the program.
In the 2011-12 school year alone, more than 10 million people took out the popular federal Stafford student loans, according to the College Board’s Trends in Student Aid report. Cooper Howes, a Barclays analyst, estimated in a report earlier this month that more than half of all borrowers would be eligible for payment reductions because of their incomes.
If you or your children are borrowers and the income-based repayment program is new to you, you should consult the Project on Student Debt’s ibrinfo.org site, which is about as clear as this complicated topic can get. The Education Department’s site is worth a thorough look, too, as is the New America Foundation’s income-based repayment calculator.
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, 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 OMB 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, because big chunks of each monthly payment will have gone toward interest and not principal.
Delisle would like to see student loan debt forgiveness become a tax-free event for everyone, and not just people who have worked as teachers or in public service jobs. ‘‘Think about it practically,’’ he said. ‘‘You forgive someone’s loans, then you stick them with a tax bill that’s equivalent to making three or five or 10 more years of payment on the loan.’’
Representative Sander M. Levin, a Michigan Democrat, has tried and plans to continue to try to get a law passed that will take away the tax burden, according to his spokesman.