According to the Federal Reserve (https://www.federalreserve.gov/releases/g19/current/), there was nearly $1.4 trillion in student loan debt outstanding in September 2016. About 60% of all college graduates are saddled with student loans; for those who go to law school, medical school, or other graduate programs, outstanding debt of $250,000 or more is not uncommon. The repayment burden is substantial for many; however, there are some strategies for paying off such debt. Some of these strategies have tax consequences; all have financial consequences.
Repayment Strategies
Graduates may have one or more student loans to repay. Repayments commence at different times, depending on the type of loan and other factors.
Grace period.
There may be a grace period before repayment begins, giving a graduate time to become financially able. There is no grace period for federal direct PLUS loans, but there is a six-month grace period for direct subsidized loans, direct unsubsidized loans, federal Stafford loans, and unsubsidized federal Stafford loans. Interest accrues during the grace period, however.
The grace period usually is extended for a student called to active military duty for more than 30 days before the grace period ends. In this case, a new six-month grace period starts after returning from active duty. Similarly, returning to school or reenrolling at least half-time before the end of the grace period creates a new grace period after again leaving school.
Consolidation.
Outstanding loans can be consolidated so that only a single monthly payment is required. Once a loan is consolidated, any grace period is ended. Typically, repayment of a direct consolidation loan, which allows two or more federal loans to be combined, is about two months after the funds have been disbursed to pay off the consolidated loans. Private loans cannot be consolidated through a direct consolidation loan. The interest rate is fixed for the life of the loan.
Rehabilitation.
A borrower and lender can agree to change a repayment plan to make payments more affordable for the borrower. For example, payments may be extended so that the monthly amount is smaller. The lender may also grant a deferment or forbearance, which temporarily postpones repayments or reduces the monthly repayment amount.
Deducting interest.
Generally, personal interest is not deductible. There is an exception, however, for interest on student loan debt. Up to $2,500 can be deducted annually on such debt by those with modified adjusted gross income (MAGI) below set amounts [Internal Revenue Code (IRC) section 221]. A full interest deduction can be claimed in 2017 if MAGI does not exceed $65,000 ($135,000 on joint returns). The deduction phases out at higher MAGI and is fully phased out at $80,000 ($165,000 on joint returns).
Strategies for Outside Help to Repay Loans
A student or graduate may not have to go it alone in handling loan repayment.
Family assistance.
Parents who can afford to do so may help a child pay off student loans. This can be done in a variety of ways, such as making a lump-sum payment or some or all of the monthly payments. If there is more than one loan outstanding, payments should be targeted to the one with the higher interest rate (e.g., a private loan versus a federal student loan). Grandparents or any other relative may also be in a position to help. When making a lump sum payment, be sure that it is used to reduce the outstanding balance and is not merely applied toward future payments.
Financial planners generally do not advise parents to help repay student loans at the cost of their own retirement savings. For example, if a parent is deciding between making a contribution to her 401(k) plan or helping a child repay a student loan, it is probably better to make the retirement plan contribution. Students have time to repay their college loans, while parents have a limited window to save for retirement.
In making payments, parents and grandparents should factor in the gift tax. There is no gift tax issue if, for example, the parent is a cosigner of the loan. But if the child is the only borrower, then payments are treated as gifts. If the amount is more than $14,000 in 2017 ($28,000 if a spouse joins in the gift), this requires the filing of a gift tax return and using part of the parent’s lifetime exemption amount. Of course, if federal estate and gift taxes are eliminated, as has been proposed, this will no longer be an issue.
Employer assistance.
Some employers are helping their employees repay student loans, and this is becoming an important recruiting tool; 80% of respondents to a survey conducted by Iontuition wanted to work for a company that offered repayment assistance (“New Survey Shows Students Want Employers to Help Manage Student Loans,” Sept. 1, 2015, http://bit.ly/2kACmvQ). For example, PricewaterhouseCoopers (PwC) pays up to $1,200 per year toward student loan repayments. Currently, about 4% of companies offer this fringe benefit, but the trend is growing (“2016 Employee Benefits: Looking Back at 20 Years of Employee Benefits Offerings in the U.S.,” Society for Human Resource Management, June 20, 2016, http://bit.ly/2kANVDf). From a tax perspective, loan repayment assistance is a taxable benefit, and is also subject to employment taxes.
Cancellation of Debt
If student loans are canceled, the burden of repayment is eliminated, but the amount forgiven usually results in taxable income. This taxable treatment applies, for example, to debt canceled under an income-based repayment program, which usually runs 20 to 25 years, as well as to debt canceled for those who are totally and permanently disabled. Cancellation of student loan debt may be tax-free in certain situations:
Government loans canceled due to a work commitment.
Tax-free treatment applies to loans forgiven because graduates work in certain geographical areas (e.g., inner cities) and in certain professions (e.g., medicine, teaching). This tax-free treatment also applies to law school graduates with loans forgiven under the Loan Repayment Assistance Program because they work for the government or a tax-exempt organization.
Healthcare professionals.
Tax-free treatment applies to loans forgiven under the National Health Services Corps Loans Repayment Program, state loan repayment programs eligible for funding under the Public Health Services Act, and state loan repayment or forgiveness through a program intended to increase the availability of healthcare services in underserved areas.
Consequences of Default
Defaulting on a student loan has an adverse effect on a student’s credit rating. This makes it more difficult, and often more costly, to obtain a car loan, a home mortgage, or make other purchases. Unlike various other types of personal loans, it is not easy to get out from under student loan debt.
Tax offset.
The U.S. Treasury has the authority to offset a tax refund for delinquent student loans owed to the federal government. The IRS notifies the taxpayer of the intent to use this offset. Taxpayers can ask questions about the offset for delinquent debt by calling (800) 304-3107. If the debtor files a joint return, the spouse can receive his share of the tax refund by filing Form 8379, Injured Spouse Allocation, with the IRS.
Bankruptcy.
Usually, student loan debt is not dischargeable in bankruptcy. It may be possible, however, to obtain a discharge in a Chapter 7 bankruptcy proceeding by showing that the debt imposes an undue hardship on the individual and her dependents. This is done through a special filing to obtain a determination for this purpose. Courts may use different standards to determine whether there is an undue hardship to the filer.
For those who file under Chapter 13 (which entails a repayment plan), no discharge is possible. The court, however—not the lender—determines the amount to be repaid and the period of repayment. During this period, no collection actions are allowed. At the end of the repayment period, the remaining balance of the loan is still owed, but it may be discharged at that point with a showing of undue hardship.
An Uncertain Future
During the 2016 presidential election, there was much talk about proposals to eliminate student loan debt. There has been little mention of this issue after the election, however. Whether there will be any action in Congress to help students is unclear. What is certain is that as interest rates climb—as evidenced by the increase in the Federal Funds Rate on December 14, 2016—the cost of repayment will only get greater. Federal student loan interest rates for 2017/18, which are tied to the U.S. Treasury’s 10-year note, will be announced in May 2017.
CHECKLIST
- ___ Does the student know when repayment must begin and how much it will cost each month?
- ___ Has the student considered a consolidation of outstanding student loans?
- ___ Does the student qualify for a deferment?
- ___ Has the student considered working at a job in an area for which debt forgiveness is available?
- ___ Can a parent or grandparent help with repayment?
- ___ Is there any employer assistance for repaying student loans?
- ___ What is the student’s option if repayments cannot be made?
