For many professionals, especially recent graduates, student loan debt is not only an expense item on their budget, it is also a major component of their financial trajectory and often a great source of anxiety. Indeed, the data show that in 2018, Americans are more burdened with student loan debt than ever before. In addition to sometimes staggering dollar amounts, those in debt must contend with a complex array of terms and variables when navigating the student loan landscape.
Like so many issues in financial planning, the solutions are not found in a vacuum, but instead depend upon related factors such as circumstances, resources, income, and priorities. How much debt do you have? Are your loans federal, or private, or both? What is your current income, and expected future income? How do you wish to balance debt repayment versus saving for retirement? The answers to these and many other questions can form a roadmap to an optimal strategy. Below are four case studies containing different scenarios, factors to consider, and possible solutions. While not exhaustive or definitive, they reflect approaches that can be taken in various situations.
Recent grads John and Melissa got married this year. John, now employed as a mechanical engineer, incurred $25,000 of federal student loan debt, and has a salary of $60,000 per year. Mary has $75,000 of her own federal debt and makes $45,000 annually as a school teacher. Given those numbers, they will be eligible on their federal loans for an income driven repayment plan. Relative to standard repayment plans, income driven plans allow for lower monthly payments calculated based on current income. Such plans can be very helpful to recent graduates starting their careers with high levels of debt and modest income.
As newlyweds, John and Melissa will be combining resources and can, of course, file a joint tax return. In most cases, the tax bill for couples will be lower if they file jointly than if they file separately, and projections in their case show that they would save approximately $1,270 by doing so. However, their filing status will also have implications on the amount of their student loan payments. Running the numbers, it appears that, under their applicable repayment plan, they would save about $2,100 in student loan payments over the course of the year if they file separately. This extra savings would more than offset the additional taxes due and boost their cash flow, so filing separately would likely be advisable in their case. Evaluating tax filing status, in the context of addressing student loans, is something couples should do on an annual basis.
Forgiveness…I and II
Megan is making nice progress in her career as a fund raiser with her undergraduate alma mater, and recently received a promotion and pay increase. She lives frugally, sharing rental and living costs with several roommates, but looks forward to greater independence in the future. Her financial ledger includes two Federal student loans, a Stafford and a Perkins, each with sizable balances, and each of which is currently on an income driven repayment plan. In addition to lowering monthly payments, such plans provide forgiveness of unpaid balances remaining after a defined period of payments (either 20 or 25 years). On the flip side, they lengthen the life of the loan, may increase the total amount paid over the entire loan term, and result in taxable income if any balance is in fact forgiven.
Since her employer is a 501©(3) organization, Megan’s Stafford Loan is also eligible for another type of forgiveness stemming from public service. Public Service Loan Forgiveness (PSLF) means that, following 120 timely payments (10 years) made as an employee of a non-profit, any remaining balance will be forgiven, tax free in this case.
With her career evolving and the recent increase in her cash flow, Megan’s priorities may shift somewhat, from minimizing monthly payments to getting out of debt more quickly. She could use her raise to increase her monthly payments on the Perkins Loan, and could also evaluate whether to refinance it through a private lender. While doing so would cause her to lose eligibility for Federal income driven repayment plans on that loan, it could also allow her to obtain a lower rate and position her to pay the loan off more quickly. In the meantime, her Stafford Loan (assuming she does not consolidate or refinance it) will remain on track for Public Service Loan Forgiveness.
Upwardly Mobile Professionals
Chris, a recently minted lawyer, will soon be completing a judicial clerkship, a job at which he has been making $70,000 per year. Undergraduate and law school loans have left him with a current balance of $170,000 in federal debt. At the conclusion of his clerkship, he will become an associate at a private firm in the city, where his salary will jump to $190,000 per year. Chris will also be marrying Katy, who earns $55,000 per year as a social worker, and who has no student loan debt. While they both wish to reduce debt, they do not want to ignore saving for retirement.
Since graduation and throughout his clerkship, Chris has been operating on an income driven repayment plan known as “Revised Pay as you Earn” (“REPAYE”). In addition to facilitating lower monthly payments, a distinct feature of REPAYE is that it places a cap on the amount of interest than can accrue. This is a benefit that has served Chris well to this point.
With the salary increase and marriage on the horizon, however, Chris might consider shifting to another income driven plan known simply as “Pay as you Earn (“PAYE”). The REPAYE plan he is currently on places no cap on the required monthly payment amount, and where salaries increase can result in monthly amounts even higher than the standard (non-income driven) repayment plan. PAYE, on the other hand, caps the monthly payment at the standard repayment amount. In addition, REPAYE, when calculating the payment amount, requires inclusion of the spouse’s income, regardless of tax filing status. Under PAYE, Chris and Katy can file separately if they choose, and exclude Katy’s income from the repayment calculation. Running the numbers in their case, it appears they could save almost $400 per month in student loan payments by switching from REPAYE to PAYE, and the additional cash flow might be added to their 401k accounts, building their nest egg and reducing their current year taxable income.
Brian and Mary, a marketing director and dental hygienist respectively, are proud of their son Will, a recent grad who has begun a promising career in the Information Technology field. For Will’s final year of school, Brian and Mary took a Federal PLUS loan for parents at an interest rate of 6.84%. They are concerned about how this debt could impede their retirement plans. There are several options they might consider.
One would be to refinance the PLUS loan through a private lender, in hopes of obtaining a lower interest rate. In doing so, they could take the additional step of establishing the new loan in their son’s name, rather than their own. This would involve many considerations regarding Will’s income and circumstances, and clear communication and agreement between parents and child.
A home equity loan or line of credit could be another means of rate shopping. In comparing, Brian and Mary would want to be aware that PLUS loans are eligible for the student loan interest deduction, while payments of interest on a home equity loan, taken for this purpose, would not be deductible.
Finally, 401k accounts can be another loan source, often with friendly rates. If resorting to this, Brian and Mary should be sure that their cash flow will allow them to pay the balance off within five years and should be aware that any unpaid balance will become taxable income upon departure from that employer.
The scenarios above show that each situation is unique and provide an idea of the many factors to be considered when addressing student loan debt in the context of one’s financial goals. Often, prioritizing between immediate needs and long-term goals is key in formulating the right plan. If you or a family member are seeking strategies to manage such debt while building wealth, please consult your Wealth Manager.
(Disclaimer: The scenarios included above are intended to be informational in nature, and do not represent financial planning advice to specific individuals. Numerical outcomes contained therein are intended as estimates based upon recent and current interest and tax rates, and are intended to reflect probable, but not guaranteed, results.Individual cases will, of course, vary.)