A frequent comment about using income-driven repayment and debt forgiveness is, “Taxes? How, why, what?” Some people avoid forgiveness due to a misunderstanding about how the taxes work and when. Let’s break the taxes down. This is not a fun topic, but it’s necessary to understand how the whole process works! 

When the Department of Education forgives the debt, that triggers “debt forgiveness income.” Debt Forgiveness Income occurs anytime a debt that was due is forgiven. Think of it as since the borrower no longer has to pay, then it’s like getting that money back. It’s kind of difficult because they don’t actually see or touch the money. But the IRS counts debt forgiveness income as ordinary income just the same. This can create some unintended consequences because the taxpayer might not actually have the income to pay the taxes.

That’s where planning comes in! We know this forgiveness event is coming. We have years to plan and prepare. So when the taxation event occurs, we’ll be prepared! 

Regarding taxation, the taxes will be due, when the forgiveness occurs.  

The second misconception is that taxation will somehow negate the positive benefits of income-driven programs. The current ordinary income tax rate in the US is at most about 39%. Meaning that for every dollar that the highest earners make, the government taxes about 40 cents. So, if the debt is forgiven, we still get to keep 60 cents of every dollar. All things considered, that’s good! That means we’re 60% in the positive! We “make” 60 cents on every dollar forgiven. And that’s at the highest tax bracket. Many veterinarians will be taxed at lower tax brackets. 

We don’t have any way to predict what the tax brackets will be in 20-25 years. So we are taking some guesses that the tax rates will be similar to what they are now. 

Using today’s tax rates, if a veterinarian has $200,000 forgiven, they will need $50,000-$60,000 ready to go to pay the IRS their debt forgiveness income. This is a chunk of change, and not many people have that lying around.  And herein lays the consternation that taxation causes.  Therefore, saving money and being ready is absolutely essential. 

The key to debt forgiveness taxation is planning. The forgiveness event and subsequent taxation are 20-25 years after graduation. That means we have 20-25 years to plan and save money in preparation for the taxes. 

This is not a time to procrastinate. Starting early will help create compounding interest. Basically, your interest will start earning interest! And that means that you don’t have to actually earn the money in your savings account. But it’s clutch that you start early, as in right after graduation. 

For example, if our example veterinarian needs to save $60,000 for a forgiveness and taxation event in 25 years, we can do the financial math!

The VIN Foundation’s Student Debt Repayment Simulator tells us that given a 3% interest rate, we need to save $137.13 per month. 3% is a fairly low and conservative savings rate, there are investments and stocks that can perform much better than 3%. But, to not overestimate, it’s best to use a conservative number. Still, using an interest rate of 3%, she will actually put about $41,000 into the savings account and she’ll earn over $19,000 in interest. 

I must point out, we have a bit of a counterintuitive scenario here. Our veterinarian is paying 6-8% interest on her student loans, using the lowest payment possible. And at the same time, she’s putting money into savings at a meager 3%. Conventional financial knowledge would say to pay the higher interest rate debt down first, then start savings. But income-driven repayment and forgiveness programs defy conventional knowledge! 

The interest on her student loans is growing, but she’s not worried! It’s going to be forgiven. 

To summarize, our veterinarian in this scenario would have paid $1,277 per month on a standard 25-year extended repayment plan, but under an income-driven repayment plan like REPAYE, she’s making a monthly payment of around $634, so she has an “extra” $643 per month. She should immediately start putting $138 per month in a savings account. She still has an “extra” $505 per month. But she can rest easier, knowing that she will pay as little as possible on her student loans and she will have the taxes ready to go when she reaches forgiveness! 

Again, it’s all about understanding how the program works and planning for the future!