If you’ve heard about getting your loans discharged after 20 years (PAYE) or 25 years (REPAYE/IBR), you should probably forget about it. Unless you quit medicine and never make a decent attending salary, all but those with the most egregious student loan amounts won’t get their loans forgiven this way. Even if you did, you wouldn’t save much money given all of those extra years of making payments.
Once you make good money, the calculated PAYE or IBR payment is capped at the equivalent of the standard 10-year repayment. If you make little enough (e.g. part-time academic primary care) to stretch out your loans for 20 years but couldn’t do PSLF, then you might have some amount forgiven, but then you would have spent a ton of money over the years on interest, and the forgiven amount is taxed at your marginal tax rate. The best reason to keep your federal loans around at a high interest rate is generally for PSLF or because you can’t yet qualify for something better.
The Tax Bomb
As we’ve discussed previously, the 20/25-year loan forgiveness baked into income-driven repayment is taxable. While achieving PSLF would be a beautiful tax-free miracle, earning IDR forgiveness will result in a big potentially-unexpected tax bomb. The less you managed to pay over two decades and the more that’s forgiven, the bigger that hit will be.
Let’s say your debt entering repayment was $500,000 at 6% (an egregious amount as alluded to above). This accrues $30k per year in interest. Under PAYE, you need a salary of $310,000 in order to just break even on that interest. Thus, it’s not that hard to imagine a scenario where that whole half mil gets forgiven after 20 years. And voila, you suddenly owe $140k in taxes (on top of paying over half a million bucks over the two decades to get there).
Forgiven debt may be excluded from taxable income if the taxpayer is deemed insolvent, which is when their total liabilities exceed their assets.
Most physicians, even ones forced to stretch out their loans over two decades, will not be insolvent. Your house, retirement accounts, etc. all count as assets. But someone living in a rented abode and spending every dollar they earn or who is status post messy divorce could find themselves insolvent depending on how grotesque their student loan situation is. An accountant would be necessary here.
The key facet of long-term loan forgiveness is that the forgiven amount is treated as income. This means that it may or may not be taxed at higher rates depending on your income that year (i.e. what bracket you are in). If you can reduce your income in the tax year that you earn forgiveness, such as maxing out pretax retirement accounts, you might be able to reduce the percentage taxed from the forgiven amount.
One way is simply to make less money in the year you’ll be claiming loan forgiveness. Unlike PSLF, there are no employment requirements for IDR loan forgiveness, just the total number of on-time monthly payments. For example, if you have always wanted to spend a year working for Doctors without Borders or taking a sabbatical, this might be the year to do it. If you decide to leave the US and work abroad, around the first $100k of your income may fall off your tax return due to the Foreign Earned Income Exclusion.
(And if you just read that and realized that you could flee the country after graduating and use that exclusion to potentially never pay any money toward your loans until the tax bomb, that’s true: call it the Expat Loophole.)
So, you’ll still need to have enough money saved up to pay your taxes, but the marginal rate may be much less. In fact, it’s not that you can’t work, it’s that you want to work only so far as the addition of your student loan “income” does not push you deep into a higher marginal tax bracket and result in a much greater fraction of the forgiven debt being taxed at a higher percentage.
Filing your taxes separately in the forgiveness year also may be a smart move if you have a massive loan, as it may shield your spouse’s income from a significantly higher bracket if you have a large forgiven amount.
Handling these sorts of issues is a rare case where a good accountant could make all the difference. At the very least, plugging it all into tax software and running it both ways would be mandatory.
The massive debt conundrum
When PSLF won’t work, the decision for massive debt is usually between refinancing and paying it down vs. paying the absolute minimum for 20-25 years and having it forgiven.
The decision-making here is more complex because you have to make some serious assumptions about your future, including what your income will be like for a very long time. Psychologically, you also need to figure between having some lean years initially in order to pay it off relatively quickly vs. make more payments over the course of at least two decades.
Again, when performing this calculus, you need to anticipate paying taxes on the forgiven amount. In this case, imagine the scenario in which you owe $400,000 at 6% in debt and essentially only make interest payments throughout your entire professional career while using income-driven repayment (e.g. salary of $260,000 in PAYE). In the case where you are magically exactly covering interest accrued and have $400,000 forgiven, you are now liable to pay the taxes due on this massive windfall come April the following year. 34% of $400,000 is a lot of money ($136k), so you’ll even need to save money on the side (probably for years) just to deal with the tax consequences. You’ll want to invest this money in order for it grow and have those dollars work harder for you. While this is doable, please know that it is not ideal. Then again, neither is being $400,000 in debt to begin with.
PAYE vs REPAYE
Before we get into the merits of PAYE vs REPAYE for 20/25-year forgiveness, let’s remember: if you can get your loans forgiven via PSLF, then all of this is irrelevant and you’d save a ton of money. Your goal for PSLF should be to pay as little as possible per month during the 120 required monthly payments. It’s not hard to imagine a 20-year plan that somehow squeezes 10 years of PSLF-qualifying payments into it.
But what about that person who borrowed $500,000 but wants to work part-time making $150,000 forever?
In this example, your salary is never big enough to pay more than the accrued interest, so you’d think REPAYE wins. A $500k loan at 6.8% accrues $34k in interest each year. The monthly payment at a $150k salary is $1102 ($13,224/year), meaning your loan continues to grow big time forever via negative amortization. You never lose your partial financial hardship—thus making the PAYE interest capitalization cap irrelevant—but the interest subsidy with REPAYE will significantly reduce the growth of the loan (and subsequently the tax you would owe when forgiven). Unfortunately, the wrinkle is in the extra five years you would need to qualify for forgiveness: 20 years in PAYE vs 25 years in REPAYE or IBR.
With a starting salary of 150k generously increasing at 5% per year, the federal repayment estimator projects PAYE forgiveness of $728k after 20 years and REPAYE $559k after 25 years while making payments of $451k for PAYE and $656k for REPAYE. At around a 35% average tax for that sum, for example, that’s a tax bill of $255k for PAYE and $196k for REPAYE for the forgiven amount due in one big lump sum. Combine the total payments plus the forgiveness tax bomb and that’s a total of $706k with PAYE and $852k with REPAYE. Because REPAYE takes longer, you pay $146k more with REPAYE. With either one, you’ll need to save for years just to pay the taxes that will come due with the forgiveness (and even with your loans “forgiven,” you’re still spending a ton of money on them).
So that’s the long-term scenario in which PAYE beats REPAYE for a single filer or non-working spouse: purely due to the 5 fewer years to qualify. But as always, these calculators make assumptions that might not be true nor reflect all of your options.
In this scenario, you’d theoretically maximize your benefits by being in REPAYE as long as you have an interest subsidy and then switching to PAYE while still eligible once you earn too much for the subsidy (if PAYE-eligible in the first place, of course). In this case, you’d get the best of both worlds: your months in REPAYE should still count toward the 240 payments needed for PAYE forgiveness, but you’re also decreasing the amount of interest accrued as much as possible. If your REPAYE payments are never able to cover interest while in REPAYE, you’d stay in REPAYE until you near the 240 months needed for PAYE and then switch right before.
If you’re married and your spouse works, then you need to use a calculator to see if your higher REPAYE payment (hopefully still with a subsidy) is better or worse than a lower PAYE payment without a subsidy coupled with any additional tax hits from filing separately. The bigger your loan and the less your spouse earns, the more likely the former is better.
If switching deviously like that sounds too good to be true, see #28 from the official FAQ:
Similarly, if you were previously in repayment under one income-driven repayment plan and later switched to a different income-driven repayment plan, payments you made under both plans will generally count toward the required years of qualifying monthly payments for the new plan.
Your servicer may not agree, but servicers are often completely wrong. See an analogous verbiage within the actual REPAYE regulations (page 67222 [yes, really]):
The statutory provisions that govern the ICR plans (which include the Pay As You Earn repayment plan, the ICR plan, and the REPAYE plan) and the IBR plan specify the types of payments that may be counted toward loan forgiveness under these plans. Generally, qualifying payments are limited to those made under one of the income-driven repayment plans, the standard repayment plan with a 10-year repayment period, or any other plan, if the payment amount is not less than the payment that would be required under the standard repayment plan with a 10-year repayment period.
It’s probably worth discussing this with your servicer before you a make a decision that might haunt you two decades in the future. No one has done this yet because no one is even close to hitting the 20-year mark, let alone in clever ways.
And lastly, it’s again worth noting that while 20 years is a leisurely payment schedule, you’d probably still spend less money just paying it down faster. Refinancing that same $500k loan even to 5% with a 10-year term would cost you around $636k to pay off (though it would admittedly also cost you $5000 a month, ouch). Don’t forget that all it takes is a bump in your salary to totally throw off your clever plan. Get that new rate down to 4% and you’re looking at closer to $607k. The bottom line is that most physicians won’t be saving actual money by going for long-term forgiveness; they’re merely spreading out the suffering.
You might feel that you’d rather take the extra money it would take to pay off your loan and invest it yourself instead. Investing on margin is a risky proposition, and you’ll never be guaranteed a return better than the current student loan interest rates. It’s probably reasonable to do this in the context of tax-advantaged retirement accounts, which have annual contribution limits. It’s a bit riskier to do this in a taxable account without any extra benefits to account for the risk. Maxing out accounts like a 401(k), 403(b), 457(b), or (likely “Backdoor”) Roth IRA is one thing, especially as pretax contributions also reduce AGI and IDR payments. Doubling down on a taxable account doesn’t have these multi-pronged benefits.
As always, you’ll have to run some scenarios for yourself, but if you’re considering long-term long forgiveness, hopefully this gives you some food for thought.