Student Loan Forgiveness Planning: Preparing for the Tax Bill
Repaying student loans is stressful, complicated, and different than repaying typical business or personal loans.
As a result, veterinary students, new graduates, seasoned veterinarians, mentors, and even financial professionals often struggle to determine the best repayment strategy for themselves or colleagues.
A major difference, typical business or personal loans normally are paid over a period of time until the balance reaches zero. Federal student loans, however, have the option to be repaid as a percentage of your income. This can either result in a balance of zero or forgiveness. Forgiveness occurs if you reach the maximum repayment period with a balance remaining.
Forgiven debt is treated as income by the Internal Revenue Service (IRS), generating a tax liability when the debt is canceled. The most common misunderstanding is what forgiveness will mean for the borrower who reaches it. Many refer to the forgiveness as the “Tax Bomb.” That sounds scary and bad. But the mathematical reality is student loan forgiveness will be a discount — a gift. A good thing!
Let’s take a closer look
Most veterinarians graduate with a student debt to income ratio greater than one. Their student debt balance exceeds their starting income. Most recently, the average student debt to income ratio of the 2020 veterinary graduates was 2.1. Their student debt balance was more than 2 times their starting private practice income. Anytime your student debt balance exceeds your income, traditional time-driven repayment methods are going to be financially difficult.
Federal Income-driven repayment options include Pay As You Earn (PAYE), Revised PAYE, or Income-Based Repayment (IBR). After choosing one of these repayment plans the borrower pays a minimum monthly payment as a percentage (10 or 15%) of their taxable income. Whenever your student debt to income ratio is greater than one, PAYE or REPAYE will provide monthly payment relief. For those with student debt to income ratios greater than two, income-driven repayment strategy will provide significant monthly payment relief and result in the lowest total repayment costs because of the forgiveness tax discount.
Forgiveness tax is a discount
Oftentimes, the monthly payment using an income-driven repayment plan is less than the interest accrual each month. The longer your monthly payment is less than the interest accrual, the more likely you will reach student loan forgiveness. The canceled debt gets treated by the IRS as taxable income. The amount of tax you will owe will depend on all of your income, adjustments, tax filing status, state of residence, and tax rates when the debt is forgiven.
The taxable fraction you will owe on student loan forgiveness cannot be higher than the top marginal federal and state tax bracket. Currently, the highest federal tax rate is 37%. The highest state tax rate is 13.3% (California). The worst case student loan forgiveness tax scenario using the tax rates in place now would result in a tax of 50.3% on your canceled student loans. Fifty cents on the dollar, otherwise known as half off, is a pretty good deal at any discount shopping sale. Taking a closer look, your total income, including your forgiven student debt, must fall into some astronomical ranges to reach those top tax brackets. Mathematically, that means your discount is most likely to be even greater, with your overall tax on student loan cancellation probably falling somewhere between 25%-35% for most veterinarians. That’s a discount of 65%-75% on your remaining student loan balance. Your tax could be less, or it could be more. The exact number will depend on the tax rates in place when you reach forgiveness. Choose whatever rate you think makes sense. Keep in mind, there are also seven states currently that have no personal income tax rates.
When the forgiveness tax becomes a discount instead of a bomb, you can see more clearly why paying more than your income requires makes little financial sense. If you make additional payments towards a balance that is ultimately forgiven and you pay a fraction of the remainder, the additional payments decrease the discount. You also have to factor in the time value of money concept. A dollar today is worth more than a dollar in the future. The payment above what is required to your student loans today is worth more to you than the higher amount forgiven at a discount to you in the future. If you’re headed towards student loan forgiveness, pay the minimum required by your income, and save for the tax on the canceled debt. You can test this mathematically using the VIN Foundation Student Loan Repayment Simulator and the “Additional Monthly Student Loan Contributions” function in the Advanced Simulator Settings section.
Once you understand the benefits of choosing an income-driven repayment and planning for the tax on your forgiven balance, you can greatly reduce the confusion and stress of your student loans.
Still, there is no doubt that it takes time and a shift of mindset, often challenged by parents, mentors, and others who are not familiar with the unique income-driven repayment options for your student loans, to come to peace with the fact that forgiveness and the subsequent tax are a discount, a gift, and not something to fear.
The alternative and more traditional approach to paying off your student loans are not wrong or incorrect by any means. However, make certain your personal situation allows you to do it. As much as we want strong will and fortitude to make the student debt statement read zero, your financial resources must allow for that pathway. Otherwise, you may put you, your family, your finances, and future at unnecessary risk.
Certain mistakes cannot be undone. Refinancing your student loans can forfeit all of the benefits included with your federal student loans. Switching repayment plans can result in capitalization of interest. Forfeiting funds paid above what is owed cannot be used in other areas of your financial planning. Requesting or allowing a student loan deferment or forbearance can keep you in repayment longer and add thousands of dollars in interest to your bill. Consolidating student loans that have qualifying forgiveness time can reset your forgiveness clock. And no one yet has a time machine to go back and start saving for retirement earlier or your forgiveness tax sooner. Before making some of those undoable mistakes, please reach out to VIN Foundation for help.
Next Question: “How do I save for the tax?”
There are as many answers to that question as there are investment strategies.
Step One: GET STARTED!
There are hundreds of ways to save for long-term financial goals, including planning for the student loan forgiveness tax bill. As with any financial target, how you get there is going to come down to your comfort. Your options fall along a spectrum from saving your money in a coffee can to using a Certified Financial Planner (CFP) and/or fee-only planner to manage it all for you.
Clearly, there are better strategies than the coffee can. The key is to get started. Start with websites like bankrate.com or nerdwallet.com to find the highest interest rate savings account. Analysis paralysis around the “how” of forgiveness planning often results in no planning at all. Find a high-yielding, no or low-cost savings account and set up automatic transfers to build that account on a regular basis.
Unfortunately, you won’t earn much of a return on a savings account, but it’s a great place to start and to build that habit into your budget. Once you have a bit of savings, then you can consider moving your savings into other investments to increase your return. The higher your overall return, the less your forgiveness tax will cost you. However, seeking higher returns also comes with increased risk.
Step Two: Increase your return
You can certainly use only a savings account for your forgiveness plan. However, you’ll have to save much more in order to reach your anticipated target. Instead, you may consider your forgiveness savings plan like you would retirement planning. Putting some of your forgiveness savings into investments like a mutual fund, target-date fund, exchange-traded fund, stocks, bonds, etc makes a lot of sense. Student loan forgiveness takes 20-25 years, depending on the plan you choose. These are long-term savings horizons where you have time to weather the ups and downs associated with more volatile investments. However, you have to be comfortable with the risks associated with that type of investing.
That said, investing has never been easier and cheaper. “Robo-advisors” like Wealthfront, Betterment, Acorns, Ellevest, Vanguard, Schwab, or whatever new one is popping up today have made it cheap and easy to invest in any combination of funds based on your risk tolerance. NerdWallet has an excellent post that reviews several of the automated services available. My wife and I use Wealthfront to help us save for the anticipated student loan forgiveness tax. This is not an endorsement of Wealthfront by any means. We went through the exercise of evaluating the available options and we decided this was best for our situation. I particularly like the frequency with which I can transfer funds into Wealthfront and their tax-loss harvesting feature which minimizes the taxes we pay each year on our forgiveness fund. However, any of them can help you with your forgiveness planning. Robo-advising services are based on the same principle: low-cost, automated, passive index investing. Most allow you to choose your risk tolerance and how much you want to invest; the rest is pretty much on auto-pilot.
That’s the low-hanging fruit for forgiveness planning investment options. But you can (and should get creative. Investing goes beyond stocks, bonds, and savings. For instance, many veterinarians use investment property(ies) or buy/start a practice to reach their forgiveness targets and other financial goals as well (and yes, you can buy more than one home or a veterinary practice even with student debt). Come up with your own strategy that matches your comfort level with investing.
Step Three: Maximize your retirement savings
What does saving for retirement have to do with forgiveness planning? Many veterinarians feel like you have to choose one over the other or they have to pay their student loans to zero before they start saving for retirement. Worse yet, I see some veterinarians using retirement funds to plan for their student loan forgiveness. The confusion can be compounded because investment services of any kind, like the Robo-advisers mentioned previously, usually allow you to open taxable or non-taxable (retirement) accounts.
I recommend using a taxable account for your forgiveness planning. Some financial planners will encourage you to use retirement accounts like a Roth or Traditional IRA to help you plan for forgiveness. Retirement plans are designed for and incentivize you to save for your future self — not student loan forgiveness. Do your future self a favor and maximize your retirement saving options for your RETIREMENT. Do not hijack savings from your future self to meet your student loan forgiveness target.
Forgiveness planning and retirement savings are separate but not mutually exclusive. You can and should do both. The income-driven student loan repayment rules actually incentivize you to do both. Maximizing your retirement contributions can reduce your taxable income which also lowers your income-driven monthly student loan payment. You pay less in taxes, have more funds to grow for your retirement, and you lower your student loan payment: win-win-win!
Working towards a forgiveness target:
What keeps me up at night are the myriad veterinarians who I know are using income-driven repayment plans but have not yet started a forgiveness fund. You can do this. You all save animal lives and comfort their owners under extreme duress — this student loan and tax stuff is just math! 🙂
With a well-diversified, moderately aggressive forgiveness planning strategy, my wife and I are more than 75% of the way to our forgiveness tax target with about 16 years to go before we may have to pay the IRS. Essentially, this means we’re about seven years ahead of schedule on our forgiveness plan. The more our forgiveness fund grows, the lower our total student loan repayment costs, because more of the gains come from compound returns (interest on interest). Starting your plan early and reaching your target early gives you more time to adjust to changes in your forgiveness estimate, weather decreases in investment performance, and eventually increases cash flow for other financial goals. Once we reach our tax target, we can reduce the risk profile of the savings plan (maybe from moderately aggressive to something more conservative) and let the money grow for the remaining time. Start your forgiveness savings plan as early as possible.
You might ask, “why not use that forgiveness plan money to pay off your student loans now instead?” Unfortunately, that would only reduce our total household student loan balance by about 19%, eliminate an asset that is growing faster than our student debt balance, require the same monthly payment due on our student loans, and still have us paying a tax on forgiveness. Although our projected tax would be lower since we would have a lower student loan balance, we would still need a plan to cover a tax. That means we would have paid more towards our student loans than necessary and hurt our family’s “balance sheet” while not improving our cash flow. Again, the forgiveness tax is more likely to be a discount than a bomb. There’s not a very good financial reason to pay more now when I will pay less later.
Income-Driven Student Loan Repayment Tip:
If you are anticipating a tax on student loan forgiveness, the most financially beneficial strategy is to pay the minimum required by your taxable income and plan for the forgiveness.
You certainly do not have to do all of this on your own. If you want a more actively managed forgiveness plan or general investing help, then you can choose to pay a CFP or financial planner to help you meet your goals. You’ll pay them for that management and advice, just like your clients pay you for your veterinary knowledge and advice. They are excellent at helping you meet targets. Your assignment is to provide them with the numerical targets you’re trying to reach. You can estimate your target by using the VIN Foundation Student Debt Center tools, like the My Student Loans feature and Student Loan Repayment Simulator.
If you pay someone to help you, make sure they act as a fiduciary — meaning they act in your best interest vs. recommending financial products that provide them a commission. CFPs usually are fiduciaries, but make sure you ask. There are also numerous other designations out there in the financial advising industry, so again, it’s always a great idea to ask them if they act as a fiduciary. Here are some good resources for finding fiduciary advisors in your area:
- Certified Student Loan Professionals (CSLP), https://cslainstitute.org/advisor-directory/
- CFP Let’s make a plan, https://www.letsmakeaplan.org
- National Association of Personal Financial Advisors, NAPFA.org.
If you are anticipating a student loan tax, start your forgiveness fund now! Use time to your advantage, to improve your chances of meeting your goal and decreasing your costs. Use this unique period of pandemic student loan repayment relief to get your forgiveness plan started, play catch up, reach your tax target sooner, or help you to boost other areas of your financial wellness. For those with federally held student loans, the pandemic has highlighted one of the many reasons why your federal student loans are so beneficial. Ask a lot of questions and adjust your plan as your circumstances change. One thing is certain — your plans will change. Leave yourself the most time to adjust to those changes and you’ll find it easier to reach your short and long-term financial goals.
Dr. Tony Bartels graduated in 2012 from the Colorado State University combined MBA/DVM program and is an employee of the Veterinary Information Network (VIN) and a VIN Foundation Board member. He and his wife have more than $400,000 in veterinary-school debt that they manage using federal income-driven repayment plans. By necessity (and now obsession), his professional activities include researching and speaking on veterinary-student debt, providing guidance to colleagues on loan-repayment strategies and contributing to VIN Foundation initiatives.