Student Loan Forgiveness

by Jonathan G. Cameron, CFP®

By early 2015, the amount of outstanding student loan debt in the U.S. exceeded $1.2 trillion. What a staggering number! Tens of millions of young professionals carry significant student debt balances. The payments may be stiff. It can take years to pay off many of these loans. Consequently, other financial priorities get postponed. Commonly we see saving for retirement pushed ahead into the future. Does this describe you?

There is Some Good News

The good news is, there are federal programs for income-based repayment and even loan forgiveness. Before you get too excited, though: only certain kinds of federal student loans qualify. These include Stafford and Grad PLUS loans. Each year, program participants verify their income and family size. The loan servicer then calculates a new required monthly payment amount. Loan payments go up or down as appropriate. The intent is to assist borrowers in making on-time payments. These payments, however, may not even cover the interest due on the loan. Consequently the loan balance grows, even while you pay on time. You can be faithful in never missing a payment, and still see your loan balance rise!

Student Loan Forgiveness: The 10-Year Income-Based Repayment Plan

The federal government forgives your student loans in 10 years if you are a government employee working in public service. The rules for this program are rigid. If you work in a qualifying job over 10 years, and make on-time payments, the Feds forgive the loan balance at the end of the term. Great deal! Borrowers need to understand the program requirements, though. Are you OK with working 10 years in public service? If so, this is a great deal. All the loan forgiveness is tax-free. Consequently, there’s a trade-off: the lower pay found in the public sector vs. ultimate loan discharge.

Student Loan Forgiveness: The 25-Year Income-Based Repayment Plan

Most student borrowers will not work in the public or non-profit spheres. There are, however, income-based loan forgiveness options for those who work in private industry. As with the 10-year program, there are specific criteria to follow to discharge your loan balance. Say your income remains relatively low. You make all your payments on time. After 25 years, that balance is discharged.

The Tax Trap

Guess what? Your taxable income increases by the amount of the loan balance forgiven after those 25 years. This can be a huge problem. This is phantom income since no actual money comes into your checkbook but you’re taxed anyway on the amount of loans forgiven. As a result, your income runs up into higher tax brackets. Your tax bill greatly increases for that one year. Clearly you don’t want to simply exchange one debt (student loan balance) for another (income tax).

Is Loan Forgiveness Worth It?

Most noteworthy, loan forgiveness will not happen without years of on-time monthly payments. One late payment, and you no longer qualify.  Clearly, with the 25-Year option, the borrower has a trade-off. On the one hand, there is a lower payment and loan forgiveness. On the other hand, there may be a significant future taxable event. The borrower needs to figure out whether it’s better to simply pay down the loan on his own within those 25 years.

Ineligible Loans

Do all loans qualify for forgiveness? No! Loans consolidated with a private loan servicer don’t qualify for either an income-based payment plan. Parent PLUS Loans are not eligible either.

Therefore, when determining whether pursuing loan forgiveness under the income-based repayment plans is appropriate, borrowers need to know what they’re getting into. And know that there is always a catch…

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Check out Jonathan's piece on Paying Off Student Loans. Questions? Feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!