As of early 2015, the amount of outstanding student loan debt in the U.S. was up to $1.2 trillion. This is a staggering number! Tens of millions of young professionals are carrying significant student debt balances. It may take years to pay off many these loans. In the meanwhile, other financial priorities aren’t met. The purchase of a first home or saving for retirement is postponed. Maybe this describes you? There are federal programs available that provide student loan forgiveness, but they come with a catch. There are a couple of programs that fall under income-based repayment that I discuss here.
Only certain kinds of federal student loans qualify for forgiveness under income-based repayment, such as Stafford and Grad PLUS loans. Each year, program participants verify income and family size. This information factors into the required monthly payment amount. Since this program is income-based, the intent is to assist borrowers whose income is low compared to their outstanding loans.
Student Loan Forgiveness: The 10-Year Income-Based Repayment Plan
The federal government will forgive your student loans in 10 years if you are a government employee working in public service, or at certain non-profits. The rules for this program are rigid. As as long as you work in a qualifying job over 10 years, and make on-time payments, the remaining loan balance is forgiven at the end of the term. Consequently, this isn’t for everyone. Borrowers need to understand program requirements and be OK with working for 10 years with only specific kinds of qualified employers. For these employees, the discharge of any remaining student loan debt after 10 years is tax-free.
Student Loan Forgiveness: The 25-Year Income-Based Repayment Plan
Most student borrowers will not work in the public or non-profit spheres. There are, however, income-based loan forgiveness options for those who work in private industry. As with the 10-year program, there are specific rules and criteria that need to be followed to have a loan discharge. If the borrower’s income remains low, payments are made on time, and there’s still a loan balance after 25 years, that balance is discharged.
The Tax Trap
However, unlike with the 10-Year plan for public sector employees, the balance forgiven is taxable to the borrower in the year of discharge. This is called “phantom income” since no money comes into your checkbook but the loan amount forgiven is taxable. This could potentially run a taxpayer up into higher brackets, thereby greatly increasing tax burden for that one year. The borrower needs to be sure that he isn’t simply exchanging one debt (student loan balance) for another (income taxes due). As with the previous plan, this isn’t for everyone. The rules are strict and in order to qualify for forgiveness a borrower needs to abide by them.
Is loan forgiveness worth it?
An important point is that loan forgiveness will not happen without years of on time monthly payments. What will be forgiven is the remaining balance. With the 25-Year option in particular, the borrower needs to determine whether paying down the loan on his or her own can be done in less time than 25 years.
One further point: those who have consolidated loans to a private loan servicer will not qualify for either income-based payment plan. Parent PLUS Loans are not eligible either.
So when determining whether pursuing loan forgiveness under the income-based repayment plans is appropriate, borrowers need to know what they’re getting into. And know that there is always a catch…
A final note: If your parents have co-signed any student loans for you, do a good thing: get a cheap term life insurance policy on yourself, with them as beneficiaries. As co-signers, they would be on the hook for this debt if you pass away. You don’t want them stuck with your remaining loan balance if something happens to you.
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