As student loan payments will likely resume for most borrowers sometime in 2021, now is a great time to review your strategy.
Let’s take a look at how the right student loan plan could potentially save you thousands in loan payments and taxes, all while helping you save for retirement.
Student Loan Terminology
Before we dive into some strategies, let’s review a few student loan terms. For this article, we'll be covering federal student loans, specifically loans issued under the Direct Program. This is virtually every new borrower after 2010.
Direct Loans are eligible for a special type of loan repayment called Income-Driven Repayment (IDR). IDR payments are based on a percentage of your discretionary income. Discretionary income is defined as your adjusted gross income minus 150% of the Federal Poverty Level. Your adjusted gross income (AGI) can be found on Line 11 of your Tax Return. It includes your salary, rental income, capital gains, dividends, and other miscellaneous income.
To go through an example, let’s assume you have $300,000 of Direct Loans, your AGI is $200,000, and you are on Pay As You Earn (PAYE). PAYE is an IDR plan that is based on 10% of your discretionary income.
150% of the Federal Poverty Level=$19,140
Discretionary Income = $180,860
Annual PAYE repayment = 10% of discretionary income, so $18,086
As you can see, student loans function a little differently than other debt. The balance, along with the loan’s interest rate, does not matter when calculating your annual payment.
How IDR Payments Work
The government created Income-Driven Repayment plans to make paying back student loans more manageable and affordable. However, I believe they severely underestimated the complexity. Several variables can impact payments, e.g., dual borrowers, income, tax deductions, occupation, family size, living in a community property state, and tax filing status.
Now, If you continue making payments for 20 or 25 years, depending on your plan, the balance is forgiven. However, that forgiven balance under the current tax code is considered taxable income in the year of forgiveness.
If you work for a 501(c)(3) employer along with certain nonprofits, you may qualify for Public Service Loan Forgiveness (PSLF). This means after making 120 payments (10 years) on an IDR plan while working at a qualifying employer, the balance of your loans will be forgiven tax-free. This can be a huge benefit, especially for medical professionals.
Given how these IDR plans work, the big variable that can be manipulated is your income, i.e., adjusted gross income. Keeping your payments low can result in a higher balance forgiven and lower taxes.
Retirement Plans & IDR
The benefit of employer retirement plans, e.g., 403(b), 401(k), and 457(b), is that they allow for pre-tax contributions. That means the dollars you put into these retirement plans reduce your income. So how does this impact IDR & student loans? Let’s revisit our earlier example:
If you contribute $19,500 into your 403(b) and your income is $200,000, your AGI is now $180,500. This results in an annual student loan repayment of $16,136.00, almost $2,000 lower than if you had not contributed to a retirement plan. Doing this over the course of several years can yield a larger balance forgiven.
Depending on where you work, some employers such as 501(c)(3) hospitals offer the ability to contribute to a 457(b) plan in addition to a 403(b). Now, if you contribute another $19,500 to your 457(b), you’ve lowered your original $200,000 AGI down to $161,000.00. Your annual payment is now $14,186.00, almost $4,000 lower.
Not only have you lowered your student loan payments, you’ve saved for retirement, and also lower your tax bill. Three major benefits!
Health Savings Accounts & Tax Savings
When you look at your employee benefits, you may see that you can access a high-deductible health plan. Joining a high-deductible health plan offers access to a health savings account (HSA). An HSA allows you to save for healthcare expenses on a pre-tax basis. That means you can contribute up to $3,600 per year or $7,200 as a family into a savings account that reduces your income.
Continuing from our example above, if we make a full HSA contribution on top of the 403(b) and 457(b) contributions, we’ve brought AGI down to $157,400.00. Student loan payments are now $4,260 lower per year. As a tax savings benefit, we saved about $12,000 annually by staying in the 24% tax bracket versus the 32% tax bracket.
Student Loan Analysis = Financial Planning.
As you can see, there are quite a few steps in lowering your student loan payments. Your student loan strategy should be incorporated within your broader financial plan and goals, not in isolation.
While these steps might sound easy on paper, it requires quite a bit of coaching to implement. In our example, we are reducing income by $42,600 annually. This is targeting a retirement savings rate of about 21%. For many people, this will create a drastic reduction in their annual lifestyle spending. To make this possible, the most important variable must be addressed, behavior. Anytime spending is cut, a tradeoff must be made. And for many people, this requires the right coaching.
If you’re looking for custom guidance from a CERTIFIED FINANCIAL PLANNER™ and Certified Student Loan Professional™, reach out to schedule an initial consultation.
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