Most federal student loan borrowers have two options for forgiveness after graduation: public service loan forgiveness (PSLF), available only for those who work for a 501(c)3 or government entity, or the longer-term income-driven repayment (IDR) plan forgiveness.
IDR forgiveness at its simplest is 20 to 25 years of payments on an income-driven plan, followed by loan forgiveness. The catch is that the loan forgiveness is taxable.
Translation: you owe what we call a “tax bomb.”
I’ve broken down how to get long-term forgiveness in five simple steps.
1. Determine if you’re a candidate for IDR forgiveness
As soon as you get out of school, you’re placed on the 10-year Standard Repayment Plan. For many borrowers, that’s a really hefty monthly payment. My loan payment was over $1,400 per month when I got out of MBA school in 2013. For me, that was like a second rent payment.
Here’s what you should consider when thinking about income-driven repayment plan forgiveness:
- Is the standard plan the right plan for me? If the payment feels too high, you might be a good candidate for IDR. If you make less per year in salary than your student loan balance, an IDR plan is definitely an option.
- Are you a candidate for PSLF? Do you work for a nonprofit or government organization, or a school? If yes, Public Service Loan Forgiveness is your best bet. You can get your loans forgiven in as little as 10 years, tax-free.
- What’s your student loan attitude? If you want to get rid of your student loans as fast as you can, it might be best to refinance or pay (even overpay) on the Standard Plan. Income-driven repayment plan forgiveness is a long-term strategy to pay the lowest amount possible on purpose. If this feels like the opposite of what you’ve been told about debt your whole life, you’re right!
If your answers to the first two questions above are “no” and you’re open to learning more, income-driven repayment plan forgiveness might be right for you.
2. See if you need to consolidate your loans
Let’s start with a definition of consolidation. In student loan land, “consolidate” and “refinance” are frequently used as synonyms. Consolidating means staying in the federal system, and refinancing means leaving the federal system and moving to a private lender in search of a lower interest rate. Consolidation, in this case, refers to keeping your loans as federal loans.
Most of the borrowers I meet aren’t sure what kind of loans they have. If you’ve borrowed recently, chances are you have Direct Loans. The word “direct” is likely in the loan name. Direct Loans have access to all IDR options. This is a good thing.
However, if you borrowed before 2010, you might have FFEL loans. These loans only have access to the Income-Based Repayment (IBR) plan. IBR calculatutes a payment amount based on 15% of your discretionary income, while the newer plans like REPAYE are based on 10% of your discretionary income. The only way to access these newer plans is to consolidate your loans.
A huge consideration when contemplating Direct Loan Consolidation is how long you’ve been paying on your loans. Have you been on IBR for 10 years with your FFEL loans? Every time you consolidate your loans, you reset your clock toward forgiveness. Your number of payments on your 20- to 25-year quest to long-term forgiveness goes back to zero. So it’s important to talk to your servicer about what repayment plan you’ve been on since you started repayment.
If you’re like some borrowers who’ve pretended their loans didn’t exist, or been in and out of forbearance and repayment without a significant amount of loan history, consolidation might be worth your time to access lower repayment options.
3. Choose the right income-driven repayment plan for you
Below are three income-driven repayment plans that offer the lowest monthly payment.
Income Based Repayment
The IBR plan is based on 15% of your discretionary income, and for most borrowers, is a 25-year repayment plan. Many borrowers choose this plan because they think it’s the only repayment plan. Student loan servicers are known to recommend this plan as well. FFEL and Direct Loans can access this plan.
Pay as You Earn (PAYE)
PAYE is based on 10% of your discretionary income, but not everyone qualifies for it. You must be a new borrower on October 1, 2007 and must’ve borrowed after October 2, 2011— weird rules, I know. The plan is only available for Direct Loans.
Revised Pay as You Earn (REPAYE)
This plan is also based on 10% of your discretionary income if you’re single, or 10% of your joint discretionary income, if married. You can’t separate income by filing your taxes separately with the REPAYE plan. This plan is only available for Direct Loans.
Once you’ve decided on the right plan for you, apply for income-driven repayment, and wait to hear back from your servicer. They will reach out to you to confirm your repayment plan and the amounts for your next 12 payments, based on your most recent tax return.
Believe it or not, you’re now on track for IDR forgiveness. Your servicer will keep track of how many payments you have made on an IDR plan, and once the clock strikes 20 or 25 years, you’ll be eligible for forgiveness on your remaining balance.
4. Do what you can to minimize your payment
Choosing the right repayment plan isn’t necessarily an easy task, that’s why Student Loan Planner exists! If you’re pursuing any type of federal student loan forgiveness, the goal is to minimize your monthly payment. You won’t pay the loan balance off completely using the forgiveness track (that’s not the goal), so don’t overpay. It’s like throwing your money out the window on a windy day.
There are some good rules of thumb to use regardless of the repayment plan you choose.
First, do what you can to maximize your pre-tax retirement savings, which reduces your Adjusted Gross Income (AGI). That could be your 401(k), 403(b) or 457 plan at work, or a Traditional or SEP IRA if you are self-employed. If you have access to an HSA, you can max that out as well.
If you’re fresh out of school and don’t feel like you can maximize these accounts yet (we all have to eat), then start by getting your retirement savings match at work. If your company matches 5%, then start there. It’s hard to believe, but so many employees don’t take advantage of the free money that their companies are offering.
After getting the initial match, try to increase your savings by 1% to 2% per year as you get raises at work. So if you were saving 5% pre-tax, consider saving 6% to 7% the following year and so on.
Also, if you’re married, you can talk to a tax pro about filing your taxes separately. At the risk of opening up another can of worms, you can save big money by filing separately on IBR or PAYE.
5. Save for the tax bomb
An often overlooked part of long-term income-driven repayment forgiveness is the tax bomb. As it stands now, for loans forgiven any time after 2025, the amount forgiven will be taxable as income to you in the year your loans are forgiven.
For example, if John has calculated that his loan balance at forgiveness will be $250,000 in 2040, the IRS considers that $250,000 as part of John’s salary for the year 2040. Yikes!
Save money automatically into a taxable brokerage account on a monthly basis for a bill like that. You won’t owe the full $250,000, you’ll owe your appropriate tax rate just like you do on your salary. Assuming a tax rate of 35%, John would need to prepare for an $87,500 tax bill.
If he has 19 years to save for that tax bill, assuming a 5% investment return in a taxable brokerage account, then John needs to save $200 to $250 per month. It’s a good idea to have that automatically withdrawn from a bank account and invested regularly.
There’s interest and talk in the political world of eliminating this tax bomb in the future, but guess what? Saving money for your future is NEVER a bad idea. Plan ahead and save money for the tax bomb; if it gets eliminated, use it for other needs or wants!
Income-driven repayment forgiveness is the right call for many borrowers, but it can feel unsettling to let balances grow for two decades or more. At Student Loan Planner, we don’t see long-term forgiveness going away, but don’t forget to save for the tax bomb!