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Calculating Your Total Out Of Pocket For Time-Based Student Loan Forgiveness



If you have student loans, your loan servicer has probably mentioned a time-based forgiveness option. This is a 20 or 25-year long program, based on the type of loans you have and when you took them out, where after paying for 20 or 25 years your loans are forgiven.


Unlike Public Service Loan Forgiveness, time-based forgiveness is taxable.

Is this program right for you?


If you have a massive student loan balance, that is more than 2 to 3 times your current and expected salary over the next 20 years, this might be a good program for you. It's best to run the math every year to continuously evaluate if time-based forgiveness is actually the least out of pocket strategy to pay off your student loans.



Getting set up


You'll need to signup for an income-driven repayment plan, such as

  • Revised Pay As You Earn Repayment Plan (REPAYE),

  • Pay As You Earn Repayment Plan (PAYE),

  • Income-Based Repayment Plan (IBR), or

  • Income-Contingent Repayment Plan (ICR)


Your payment will change over time, as your income does, but the formula stays the same. Depending on the repayment plan you are on, expect your payment to be 10% to 20% of your discretionary income. Your discretionary income is your adjusted gross income minus 150% of the poverty line based on your household size.



Annual requirements


Every year, you will need to renew your income-driven repayment plan with your loan servicer. Failure to renew automatically places you in the 10-year repayment plan, which is typically a much larger payment.



Total cost of monthly payments


To find out the total cost for staying on an income-driven repayment plan for 20 or 25 years, you'll need to do some math. If your salary will remain relatively flat, growing at 3% with inflation, the math is easier.


I'm assuming Sally Student makes $37,500 and is single with no kids.


For the first year, Sally's payment roughly is $161.75. We'll need to map out her payment over the next 20 years in a spreadsheet, like this:

I'm assuming a few things here, (1) the poverty line stays the same - it won't, (2) her income is growing at 3% every year - we don't have a crystal ball to know this for certain, and (3) she is on REPAYE.


Sally can estimate to pay about $64,584 over 20 years on REPAYE.


Now that we have the total out of pocket for Sally's student loan payment, we have to add the tax burden at the end.



Tax burden


After 20 or 25 years, you can apply to have your loans forgiven with your loan servicer. This is a taxable event. Here's an example to help figure out how much tax you could owe:


Sally Student

Student Loan Balance at Forgiveness: $100,000

Adjusted Gross Income at Forgiveness: $65,000

Filing Status: Single, No Kids

Standard Deduction: $12,200


Getting Sally's student loan balance at forgiveness is difficult. However, if she owed $100,000 when she started making income-driven payments, we can assume her loan balance grew or remained fairly constant if she received interest subsidies. Her first monthly payment was $161.75 which is not nearly enough to pay the interest, if her loans were at 6%, of $500 a month.


Based on the 2019 tax tables, which will probably change over the next 20 years, Sally is in the 22% income tax bracket. That means every dollar she makes between $39,475 and $84,200 is taxed at 22%.


Normally, Sally would owe about $7,475 in federal income taxes.


In the year her student loans are forgiven, Sally is taxed on $165,000. Her new taxes are roughly $30,845. She was bumped up to the 24% income tax bracket, so every dollar she earns between $84,200 and $160,725 is taxed at 24%.


Sally could owe $23,370 more in federal income taxes from having her student loans forgiven.

In 20 years, it's possible Sally has saved enough to pay for the tax burden of having her student loans forgiven. To make sure, Sally should save $100 a month, each month for 20 years, in a separate savings account.



Total cost


For Sally Student, the total cost to have her $100,000 in student loans forgiven using time-based forgiveness is about $87,955. We got this by adding the total out of pocket for her monthly payments to the tax burden at the end.



Pros


For Sally, she could end up paying less in total by using time-based loan forgiveness than she owed. However, we made a few assumptions that if not true, could end up costing her a lot more.


Sally has time to save towards the tax burden at the end of 20 years, and if she starts in year one - she only needs to save about $100 a month to cover the $24,000 in extra taxes in year 20.


Cons


Time-based forgiveness is not for everyone. If Sally's income grew more than we planned over time, her total out of pocket could end up being much more than $87,955. As her income grows, rerunning the math could show Sally that it's cheaper to just pay her student loans off instead of waiting for forgiveness. Sally should also rerun the math if she gets married or has children as this would change her monthly payment over time.


If Sally does not save towards the tax burden at the end, she could be faced with $24,000 in taxes she cannot afford to pay. Essentially turning her student loan debt into tax debt.



If you are planning to use time-based forgiveness for your student loans, be sure to run the math every year as you are renewing your paperwork with your loan servicer. Use realistic assumptions for your income over time, and don't forget to add the estimated tax burden to the end.