Paying nothing on an Income-Based Repayment (IBR) student loan? You might have missed one terrifying fact

I have to apologize for the apocalyptic headline. Sometimes you just have to talk about important things by making it seem like the house is burning down—because it might be. What I'm writing about here is a fire-sized situation, and I can't let it go on any longer without sharing what I know.

There's a dangerous trend I've seen repeatedly with folks on income-based student loan repayment plans, and it's clear to me that there's a critical piece of information missing from our general understanding of how these work.

As you may already know, income-based repayment (IBR) plans are offered on federal subsidized and unsubsidized student loans, in an attempt to make them more manageable for people to pay off. They extend the repayment term from the standard 10 years to either 20 or 25 years, while capping your monthly payment at 10% or 15% of your discretionary income. Sounds good, right? But two other features of these plans are responsible for an epic problem looming in the future when the term ends. They are:

  1. If your income is low enough, you could qualify for a payment that doesn't cover the accumulating interest, or even pay nothing.

  2. At the repayment term's end, the remaining balance is forgiven.

What's wrong with that?

It sounds like the one sensible plan left in this world—but there's a catch: Any remaining loan balance that is forgiven at the end of a 20- or 25-year term of an IBR plan is considered taxable income by the IRS. [Cue audible gasps of horror]


Without knowing that one detail, you might happily fall into a group of graduates who've acquired substantial student loan debt, but are in no hurry to pay it off. You graduated with job prospects that place you in potentially lower-income lines of work (like artists, writers and musicians) and made the conscious decision to keep your income as low as possible and pay nothing on your loans, waiting until they are forgiven.

At the school where I received my Master of Fine Arts degree, it's now quite easy to come out after two years with $100,000 of loans with an average of 6.5% annual interest. If you stick with the standard 10-year loan term, you'd be required to make monthly payments of $1,135 — which is no easy task, so the idea of sliding under the radar for a couple of decades may sound appealing. But here's what could happen.


If you qualify to pay nothing and stick with it…

Your loan interest, accruing at 6.5% annually, could bring the balance of your loan beyond $500,000 in 25 years. This amount would be forgiven, but it would also be reported as income on a 1099-C and sent to the IRS.

A half-million dollars of income in one year for single filers in my home state of California (at 2017 income tax rates) will come with a tax bill north of $200,000. Yikes! This may arrive at a time when you could be sending your own kids to college, setting your eye on retirement, or perhaps you’re just sick of the hustle and wanting more financial padding in your life.

If you aren't able to come up with the entire amount due, you'll likely be subject to more penalties and interest as you get onto the treadmill of another painful payment plan. And just so we're clear, the government makes it next to impossible to get out of paying tax owed — even bankruptcy won't discharge it.


Why don't more people know about this?

In a simple Google search I found misleading financial articles touting loan forgiveness as a secret strategy for getting off scot-free, with the potential tax bill given a quiet mention at the end. I've also had clients tell me about debt counsellors offering up the 'pay-nothing' solution, going so far as to advise loan-holders to file taxes separately from their spouses to keep their income as low as possible. This means that along with accruing interest, they're likely paying higher annual income taxes, as the Married Filing Separately option generally disqualifies tax payers from common deductions and results in a higher tax bill.

IBR plans assume a 5% increase in salary per year, so for most people, even if they start off on the low end of the income spectrum, in all likelihood they'll be debt-free before the clock strikes 25 years. The people I am worried about are the ones whose educations are inordinately expensive and who graduate without a clear income path — which I see frequently for people in creative fields. Many of these folks have honed ninja-level frugality skills, which allows them to keep the 'pay-nothing' plan going without realizing where they're headed.


You know who you are

Now I'm not saying that IBR plans are always a bad choice — they're not. And if you're at least covering the interest with your monthly payments while your income grows steadily over time, IBRs may be the best option.

I am speaking directly to those who are purposely constraining their income because they think they've found a loophole. I assure you, the IRS has seen this strategy coming a mile away and has a painful strategy to disincentive it.

I've learned in my life that it's always harder to pay for things later. Our expenses increase throughout our lives as we add spouses and children and plenty of other complexity. It's hard for me to imagine a good case for delaying payment on your student loans, as painful as they are. And if you are purposely making your own personal economy smaller to evade loan repayment, you could also be missing out on building in financial safety nets, tax-advantaged retirement savings, and plenty of other important resources to protect yourself, your family, and your autonomy.

I want you to come out of the shadows, be your biggest self, and earn what you deserve.