There are two main ways to receive forgiveness on your federal student loans: 1) Public Service Loan Forgiveness; or 2) Reaching the maximum repayment period under an income-driven repayment plan (IDR), like Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE).
Each income-driven plan has a maximum amount of time that you're allowed to make payments. When you reach the maximum number of payments under a respective IDR, any remaining unpaid interest or principal amount is forgiven. Currently, forgiven amounts are treated as “canceled debt” by the IRS (https://www.irs.gov/taxtopics/tc431.html). Generally, canceled debt is treated as ordinary income, thus taxed at your marginal income tax rate during the tax year the debt is forgiven. However, The American Rescue Plan Act of 2021 included a provision that specifically exempts forgiven student debt from being treated as taxable income if canceled between 2021 through 2025. Not only is PSLF eligible for non-taxable forgiveness, but reaching forgiveness using an IDR is currently also non-taxable. There is a chance that Congress could extend the forgiveness tax exemption or let it expire after 2025. If your IDR forgiveness will occur beyond 2025, then you should be planning for a potential tax on forgiveness until the law says otherwise.
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IDR Aspects
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IBR 2009
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PAYE
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IBR 2014
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REPAYE
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Maximum repayment period (in years)
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25
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20
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20
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20 or 25*
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Maximum repayment period (in months)
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300
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240
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240
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300
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Forgiveness taxable
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Yes
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* REPAYE forgiveness occurs after 20 years if all of your loans are for an undergraduate education. If any loan is for graduate/professional education, then the maximum REPAYE period is 25 years. Veterinary school is graduate/professional school so any veterinarian with student loans will have a 25-year maximum repayment period if using REPAYE. Please note that the VIN Foundation Student Loan Repayment Simulator only projects the 25-year maximum timeframe for REPAYE.
With high starting student loan repayment balances and maximum repayment periods of 20 and 25 years, it is quite possible for the forgiven amount to be higher than your starting balance due to unpaid interest. You can test various repayment scenarios using the VIN Foundation Student Loan Repayment Simulator.
How do we account for student loan forgiveness when it does occur? First, no one can tell you what the income tax rates will be when your taxable loan forgiveness occurs and we probably will not see a large group of borrowers hit student loan forgiveness until 2032. However, we can make some reasonable assumptions based on historic and current federal and state income tax rates. Currently, the highest 2022 federal income tax rate is 37% and begins at incomes over $539,900 for single filers and $647,850 for married joint filers. Keep in mind that tax brackets are also adjusted each year for inflation. For example, in 1997 (21 years ago), the top federal tax bracket started at incomes over $271,050 per year for single filers and was taxed at a rate of 39.6% (higher than the top marginal tax rate today).
For illustration, let’s say you have a total taxable income plus a forgiven balance of $500,000 in 20 years under PAYE, and for the sake of simplicity, the federal tax rates and brackets are the same as they are now. Again, the tax brackets are adjusted annually for inflation. When forgiveness occurs, we'll assume you are married and plan to file your taxes jointly.
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Tax bracket for Married Joint Filers
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Calculation
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Tax amount
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First $20,550 is taxed at 10%
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0.10*$20,550
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$2,055
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Amounts between $20,551 and $83,550 taxed at 12%
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0.12*($83,550-20,551)
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$7,560
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Amounts between $83,551 and $178,150 taxed at 22%
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0.22*($178,150-83,551)
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$20,812
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Amounts between $178,151 and $349,100 taxed at 24%
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0.24*($349,100-178,151)
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$41,028
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Amounts between $349,101 and $431,900 taxed at 32%
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0.32*($431,900-349,101)
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$26,496
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Amounts between $431,901 and $647,850 taxed at 35%
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0.35*($647,850-431,901)
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$23,835
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Amounts over $647,850 taxed at 37.0%
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0.37*($0)
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$0
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Total Tax Amount
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Sum of tax amounts
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$121,785
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Effective Tax Rate
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$127,179/500,000
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24.4%
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Marginal Tax Rate
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Highest tax rate
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35.0%
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Under this example scenario, ideally, you would plan to have enough saved to cover the tax liability of $121,785. If you use a very conservative estimate of $125,000 to have on hand for the tax due, you could save $125,000/240 months = $521 per month to cover the tax liability.
Alternatively, you could save for the tax liability using investments (money market, certificate of deposit, equities, bonds, annuities, life insurance, etc, or a combination thereof) in an effort to earn interest on your forgiveness savings. For example, if you were to receive at least a 3% return on your forgiveness savings, you could reduce your $521/month savings plan to $380/month in order to have $125,000 on hand to cover your forgiveness tax liability from the example above.
Estimating your potential forgiveness amounts and planning for a possible tax liability can reduce your overall loan repayment costs substantially.
Let's say you borrowed $220,000 in federal student loans to get to and through veterinary school and accumulate about $30,000 of unpaid interest during school. If we run a simulation of your repayment using a starting income of $100,000/year increasing by 3% per year and assume a family size of 1 for the duration of repayment using PAYE, your total repayment costs might be $280,265 assuming a 30% tax on amounts forgiven and a forgiveness savings plan return of 3% per year.
Effective Annual Interest Rate
If you’ve paid $280,265 in total under PAYE including the forgiven amounts, that means you have paid $60,265 in interest over 20 years (amounts above what you borrowed, $280,265 - $220,000 = $60,265). The proportion of your total interest above what you borrowed = $60,265/$220,000 = 0.27. If we annualize that by the 20 years you paid that loan, your “effective annual interest rate” equals 0.27/20 * 100 = 1.37% per year.
The effective annual interest rate calculation will help you compare repayment under an IDR vs. a private consolidation loan and help you understand how much it is costing you to pay your student loans back under income-driven repayment. Oftentimes private consolidation loans will look enticing because of the seemingly lower variable or fixed interest rate that you may qualify for based on your credit history. However, if you know how the IDR plans and forgiveness affect your repayment costs, you can better assess whether or not that private loan refinance offer will save you money or if it actually does make sense to pay more than your minimum monthly income-driven payment requires.