Income-Based Repayment Is A Trap!

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If you are a recent law school grad, you may have taken advantage of some student loan repayment plans that are slightly less awful than normal student loan repayment plans. You pay a fixed percentage of your (probably regrettably more meager than you would like) discretionary income and at the end of 20 to 25 years, voila! All is forgiven. Sounds…well, if not great, tolerable.

Except for the part where you could be hit with an enormous tax bill at the end of it all.

Specifically, [a ‘tax bomb’ is] set to go off in 2032, the first year when the loans qualify for debt forgiveness. At that point, the forgiven debt turns into “cancellation of debt” income under the tax code, taxed as ordinary income, says Southern Methodist University law professor Gregory S. Crespi.

How enormous are we talking? Super enormous.

For an IBR or PAYE law graduate enrollee with a $200,000 or larger unpaid debt at the time of their debt forgiveness this may well mean a combined federal and state income tax bill on this additional attributed income of at least $50,000 up to perhaps $100,000 or more [.]

Two pieces of (sort of) good news: (1) this only affects grads from 2012 to 2015 – about 30,000 unlucky souls. (2) You could avoid this tax hit if you basically have no other money or assets. As Steven Chung points out, there is an insolvency exception where if the taxpayer can show that his liabilities exceeded the value of his assets immediately prior to the forgiveness, then the cancellation of debt income as a result of loan forgiveness will not be taxable. However, Chung notes that those assets can include retirement accounts, home equity, and all personal assets.

So the trick is to just stay relatively poor. Easy enough!

Featured image: “Timer bomb isolated on white background 3D” from Shutterstock.

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  • That is an exceptionally depressing scenario.

  • Paul Spitz

    You can’t wipe out student loan debt via bankruptcy (thank you, Congress, for screwing over millions of students), but you can wipe out that tax bill through bankruptcy, when it comes, if I recall correctly. If you had a lot of credit card debt at the same time, it could be a smart business move.

    “Bankruptcy, it’s not just for United Airlines!”

  • Jamie Sutton

    My understanding after talking to a few tax attorneys is that this “tax bomb” only applies to standard IBR forgiveness. If you have the 10-year Public Service Loan Forgiveness program, the forgiveness is not taxable.

  • Shah

    I’m one of the people affected by this and I can tell you I’m ok with it. I knew about this in law school when our financial aid people held a seminar and everyone should be planning accordingly. Paying the tax bill is still significantly cheaper than paying the loan. Financially speaking, it is still a “good deal.” It sucks to have to pay it at once but that is the trade-off