Here’s Why You Should Think Twice About That Income-Based Repayment Plan

income based repayment
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When Amber and Danny Masters finished law school and dental school, they had nearly $600,000 in student loan debt between the two of them.

Amber Masters, who finished school a year earlier than her husband, took a job as a judicial law clerk that was “not a huge money maker,” she said. Danny Masters graduated from dental school in 2016 and recently started his first job as a dentist.

Though they anticipate someday earning significantly more money, for now, they’re just starting out in their careers and taking advantage of as many side gigs as they can.

With help from a consultant, they calculated all their options for paying down that debt. They studied several income-based repayment plans, which are federal student loan repayment plans that would extend their repayment periods and lower their monthly payments based on their incomes.

A lower monthly payment would’ve meant they had more spending cash each month. And the fact that any remaining balance on their loans would be forgiven after 25 years of payments certainly sounded appealing.

But after student loan planner Travis Hornsby crunched their numbers, the Masterses realized they’d be paying $119,000 in taxes on that forgiven debt. And thanks to interest, they would’ve paid more than $1.3 million for $600,000 in debt.

Take a lesson from this husband-and-wife team, who are sharing their student loan repayment story on their blog Red Two Green, before you jump feet first into an income-based student loan repayment plan. When you’re staring at a mountain of debt right out of college, these plans may sound like a godsend. But in reality, things aren’t so black and white.

A Quick Lesson on Income-Based Repayment Plans

Broadly speaking, these plans determine your monthly payment by looking at your discretionary income, family size and other factors. They typically cap your monthly payment at 10% to 20% of your discretionary income. According to the Obama White House, they’re designed for people who have a high amount of debt compared to their income.

“As a general rule, anyone who would have to eat rice and beans to repay their student debt in full over 10 years probably needs to use income-driven repayment options,” Hornsby said.

These plans give you longer to pay off your loans, too. Under a standard repayment plan, you’ll pay off your loans in 10 years. Under an income-based repayment plan, you’ll make payments for 20 to 25 years, and then the lender will forgive any remaining balance.

That longer repayment period means you’ll pay more interest than you would if you paid off your debt sooner. But the real zinger comes when your remaining balance is forgiven in 20 or 25 years.

Under the current tax code, you’ll owe taxes on the amount of forgiven debt in the year the lender forgave it, according to the IRS. That’s on top of any other taxes you’d normally pay that year. The IRS treats forgiven or canceled debt like any other income, so it is subject to the same tax rates.

“The income-based plans are an affordable option, but may not be the most ideal long term,” said Sarah Hamilton, student loan counseling supervisor for Take Charge America, a nonprofit credit counseling organization.

How You Could Avoid Paying Taxes on Forgiven Debt

There is one exception to this rule, according to the IRS. If your debt is forgiven or canceled as part of a program that requires you to work for a certain period of time or for a specific type of employer, you don’t have to report it as income.

These programs exist for teachers who work in low-income schools, doctors who work in a specific geographic area or in a particular field and nurses who work in specific facilities, among others.

You can also avoid paying income taxes on any forgiven debt by working for a nonprofit or government agency for 10 years under the federal Public Service Loan Forgiveness program.

What else can you do to avoid paying income taxes on your forgiven student loan debt 20 to 25 years from now? Lobby your elected officials to change the tax code and create an exception for debt forgiven under income-based repayment plans.

In the meantime, you should probably keep your impending tax bill in mind and start saving as soon as you can, according to Ryan Frailich, a financial coach and planner who runs Deliberate Finances.

“I’d be doing clients a tremendous disservice if I told them to not worry about it, not plan for it, and then either the laws stay the same or the laws get even less borrower-friendly, and they end up with a huge tax bill that they haven’t planned for,” Frailich said. “If they plan for it and wind up not having to pay it, well great, now you’ve got a pile of savings to figure out what to do with it.”

Whatever You Do, Don’t Default

Of course, you can always pay down your debt faster to pay less interest and avoid income taxes on any forgiven debts. That’s what Amber and Danny Masters decided to do.

They enrolled in an income-based repayment plan, which dropped their minimum monthly payments from nearly $7,000 a month to $0 a month. That took some of the pressure off the young couple, who didn’t have to worry about defaulting on their loans because they couldn’t make the massive standard payments.

The Masterses opted to enroll in the REPAYE program because they had graduate  school loans and were able to get a 50% interest subsidy if their monthly payment didn’t cover the interest accrued that month. They expect their monthly payment to go up when they resubmit their financial information to REPAYE this year because Danny Masters recently got his first job as a dentist, which boosted their income.

Once Danny Masters started working, the couple began making aggressive payments. They  eventually plan to refinance their debt through a private lender.

Today, the couple puts roughly $8,000 a month toward their payments, with a goal of increasing that to $12,000 a month in the future. Amber Masters is working to pass the bar exam in Oklahoma, where the couple recently moved, so she anticipates a salary increase soon. They also hope to increase their income from various side gigs.

If you have to choose between defaulting on your loans and signing up for an income-based repayment plan, experts say you should pick the latter. Even if you’re making small monthly payments under the plan, those payments are still boosting your credit score.

“For those who worry about the tax liability, they really have to change their perspective,” said Joshua Cohen, a lawyer based on the East Coast who specializes in student loans. “Don’t worry about what will happen in 20-25 years from now when the real issue is staying out of default now. If (income-based repayment) is the only affordable payment plan, take it. Worry about the tax issue when getting closer to forgiveness. For now, survive.”

No matter what, Amber Masters said it’s important to stay patient and committed to paying off your college debt. With time and a little research, you’ll be able to make it happen, no matter which repayment plan you choose.

“Your student loan debt does not control you, you control it,” said Amber Masters. “Student loans can take a little time to pay off. It is easy to get overwhelmed by the task of having to pay off your loans, but you just have to keep making payments, do your best to make extra payments, and keep your end goal in sight, and eventually you will get there.”

Your Turn: How are you paying off your student loans?

Sarah Kuta is an education reporter in Boulder, Colorado, with a penchant for weekend thrifting, furniture refurbishment and good deals. Find her on Twitter: @sarahkuta.