Broke, unemployed and miserable law school grads may be aware of an alternative student loan repayment program called Income Based Repayment or IBR. Google it if you want to know the details. But in essence, IBR reduces your monthly student loan payments based on the income (if any) you report on your tax return. If your income is low enough, you pay nothing. And after 25 years, if the loan isn’t repaid, then the balance is forgiven. A newer program known as Pay As You Earn (PAYE) allows you to pay an even lower amount and the debt is discharged after 20 years. IBR and PAYE are only available for federally backed loans and not for private loans. But you are required to reapply for IBR every year and the loan amount forgiven is considered income for tax purposes. So under the federal tax law, you have to pay real income tax with money you don’t have.
For the recent grad who is unemployed, IBR or PAYE sounds like a sweet deal especially in a bad economy. You have a lower chance of defaulting on payments which will negatively affect your credit. You get some financial breathing room without having to seek forbearance while looking for a job and later developing your career. Finally, as soon as you “make it”, you can pay the loan off without struggling. And if things don’t work out, then at least the debt will be forgiven eventually. This strategy is fine if you have a relatively modest amount of student loan debt with a modest interest rate. And this is what Congress intended when they introduced IBR.
But what if you have a high student loan balance and low pay with little chance of career advancement? If you are on IBR and especially PAYE, the above scenario is also possible. But two other scenarios are also possible. Both to some level will make you Indentured, Broke and Reviled.
The first and more honorable option is to pay as much as possible until the balance is paid off or is reduced to a comfortable level. IBR is nothing more than a safety net in case of a layoff some other emergency. This may result in delaying or even forgoing other life priorities like traveling, getting married, having a family, having a retirement account and even health insurance.
The other – and increasingly likely – possibility is to strategize your finances in order to pay the minimum amount possible for the 20 to 25 year period. Current legal employment trends indicate that you will be paid a pittance for several years and your $100,000+ student loan balance will increase during that time. And let’s be honest – at some point, you will want a family, a car, a house and essentially live like a lawyer. Once you turn 40 and you see a $100,000 debt that can be forgiven in 10 years, there is little incentive to pay it. If you can find a legal way to avoid paying the debt with little financial sacrifice, wouldn’t you take it?
In this case, IBR is a form of bankruptcy. In the meantime, you may be banking on a reinstatement of bankruptcy discharges for student loans.
What about income taxes on the discharged debt? There is an exception where you don’t have to pay income tax on the discharged debt so long as you can show that you are “insolvent”. The IRS rules say that a person is insolvent when their liabilities exceed their assets. Also, taxes are dischargeable in bankruptcy so long as certain rules are followed.
So in the end, if you want to minimize the monthly payments and maximize the loan forgiveness under IBR and PAYE, you can only make up to a certain amount of money during the 20-25 year period. Also, you must limit asset acquisition during this period which can be problematic if you want to save for retirement. If the forgiven amount is large enough, you better have a good tax professional prepare your return because the IRS may be inclined to audit it.
The biggest problem with IBR is that Congress or the President may modify it at any time, especially if the powers that be are seeing that IBR is not being used for its intended purpose. There is a reason why the loans will be forgiven after 20-25 years – the government anticipates the loans will be paid back during this time. As tuition continues to increase and salaries decrease, IBR will eventually be the default option for future graduates. On a large scale level, this will ultimately lead to massive losses to the government. One congressman saw this coming and proposed a bill repealing IBR and replacing it with mandatory 15% salary reductions. If IBR is not modified soon, then it may get to the point where the public will be dependent on it and will be “too big to fail”.
On an individual level, IBR may create a financial headache, depending on one’s tolerance for debt management. Unless you can come up with some income finessing strategies or live like Octomom, you will have to turn down raises, decline promotions or even stay home altogether. Because any increase in income will go straight to Sallie Mae.
IBR is ultimately a temporary relief that may ultimately lead nowhere. If after a number of years, you continue to rely on IBR, I strongly suggest planning for bankruptcy.