Forgivageddon - punitive loan forgiveness

[sazerac]

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I did some more research on forgivageddon - the upcoming wave of student loan forgiveness that will trigger massive taxes - and wanted to share what I've found.


(1) What is forgivageddon?

Forgivageddon is the term for the wave of taxable student loan forgiveness that happens after twenty (PAYE) to twenty five (IBR) years of student loan payments. Since this loan forgiveness is a taxable event, the debtors will not have the debt anymore, but they will have a large tax bill. This tax bill might be larger than the debtor's annual income and/or net worth.

Since these loan forgiveness programs are relatively new, forgivageddon will start in the early 2030's.


(2) Is there an example with today's numbers?

Say a medical student graduates medical school at age 26 with a total student debt of $400,000 and an average interest rate of 7.4%. After a four year residency with the debt in deferment, the debt will be approximately $500,000 once the doctor is an attending.

At age 30 now, the attending gets a job with a for-profit employer and earns $250,000 a year. The doctor chooses to remain on the Pay As You Earn program, paying approximately 10% of their income towards their loans, or approximately $25K a year. Meanwhile the interest on the loans the first year is $37,000.

Since the loan payments aren't even covering the interest, the loan principal grows exponentially every year, and twenty years later by the time the doctor is 50 years old, the loan amount will be approximately $1,000,000 dollars.

At age 50, after twenty years of PAYE payments, the loan will be forgiven. However the doctor will have to report $1,000,000 in taxable income that year, resulting in a tax bill far in excess of annual salary.


(3) Is loan forgiveness required? Can a person decline the loan forgiveness option and continue to remain on PAYE, paying 10% of income in perpetuity?

I believe the answer is no. Here is the current law: http://www.law.cornell.edu/uscode/text/20/1098e

Pay particular attention to 20 USC § 1098e (b) (7). "the Secretary shall repay or cancel any outstanding balance of principal and interest due on all loans made under part B or C". It says the Secretary SHALL repay. Not offer, not suggest, not merely make available as an option, but the Secretary SHALL repay the loan.


(4) What happens if there simply isn't enough money to pay the tax bill?

Here is where it gets interesting. While ordinarily taxes are notoriously difficult to get out of, and most financial planners suggest paying taxes with a credit card if necessary because the financing options available through the IRS have even higher interest rates, there is one loophole for taxable loan forgiveness, Form 982 (http://www.irs.gov/pub/irs-pdf/f982.pdf).

If you read between the lines of Publication 4681 (http://www.irs.gov/pub/irs-pdf/p4681.pdf), the gist is that the amount of loan forgiveness that can be taxed is limited to your net worth (assets minus liabilities), not including the liability of the debt forgiven. So if your loan forgiveness is $1,000,000 but all of your furniture and bank accounts and cars and the equity in your house in total is only worth $350,000, then you will be hit with taxable income of $350,000 and the other $650,000 of loan forgiveness will be a non-taxable event.

The IRS expects you to borrow against or liquidate enough of your assets (approximately one quarter to one third of your net worth) to pay your tax bill, at which point both your student loan debt is eliminated and your taxes are paid in full.


CONCLUSION: For today's medical students who borrow the full cost of private undergraduate and private medical education, defer loan payments through residency, earn an average doctor's income, and make the minimum loan payments allowable through PAYE, their expected loan payback will be a 10% tax on income for the next twenty years (which ironically is often quite close to the original loan principal!), plus taxes on the smaller of either (1) their loan forgiveness in full or (2) their net worth after forgiveness.

The twenty years of annual loan payments will always be a manageable portion of current income, and the loan forgiveness at the end, while financially painful, will not send anybody into negative net worth territory.

 

[DrMidlife]

Thanks for digging in. This affects an awful lot of people.

 

[cincincyreds]

I did some more research on forgivageddon - the upcoming wave of student loan forgiveness that will trigger massive taxes - and wanted to share what I've found.


(1) What is forgivageddon?

Forgivageddon is the term for the wave of taxable student loan forgiveness that happens after twenty (PAYE) to twenty five (IBR) years of student loan payments. Since this loan forgiveness is a taxable event, the debtors will not have the debt anymore, but they will have a large tax bill. This tax bill might be larger than the debtor's annual income and/or net worth.

Since these loan forgiveness programs are relatively new, forgivageddon will start in the early 2030's.


(2) Is there an example with today's numbers?

Say a medical student graduates medical school at age 26 with a total student debt of $400,000 and an average interest rate of 7.4%. After a four year residency with the debt in deferment, the debt will be approximately $500,000 once the doctor is an attending.

At age 30 now, the attending gets a job with a for-profit employer and earns $250,000 a year. The doctor chooses to remain on the Pay As You Earn program, paying approximately 10% of their income towards their loans, or approximately $25K a year. Meanwhile the interest on the loans the first year is $37,000.

Since the loan payments aren't even covering the interest, the loan principal grows exponentially every year, and twenty years later by the time the doctor is 50 years old, the loan amount will be approximately $1,000,000 dollars.

At age 50, after twenty years of PAYE payments, the loan will be forgiven. However the doctor will have to report $1,000,000 in taxable income that year, resulting in a tax bill far in excess of annual salary.


(3) Is loan forgiveness required? Can a person decline the loan forgiveness option and continue to remain on PAYE, paying 10% of income in perpetuity?

I believe the answer is no. Here is the current law: http://www.law.cornell.edu/uscode/text/20/1098e

Pay particular attention to 20 USC § 1098e (b) (7). "the Secretary shall repay or cancel any outstanding balance of principal and interest due on all loans made under part B or C". It says the Secretary SHALL repay. Not offer, not suggest, not merely make available as an option, but the Secretary SHALL repay the loan.


(4) What happens if there simply isn't enough money to pay the tax bill?

Here is where it gets interesting. While ordinarily taxes are notoriously difficult to get out of, and most financial planners suggest paying taxes with a credit card if necessary because the financing options available through the IRS have even higher interest rates, there is one loophole for taxable loan forgiveness, Form 982 (http://www.irs.gov/pub/irs-pdf/f982.pdf).

If you read between the lines of Publication 4681 (http://www.irs.gov/pub/irs-pdf/p4681.pdf), the gist is that the amount of loan forgiveness that can be taxed is limited to your net worth (assets minus liabilities), not including the liability of the debt forgiven. So if your loan forgiveness is $1,000,000 but all of your furniture and bank accounts and cars and the equity in your house in total is only worth $350,000, then you will be hit with taxable income of $350,000 and the other $650,000 of loan forgiveness will be a non-taxable event.

The IRS expects you to borrow against or liquidate enough of your assets (approximately one quarter to one third of your net worth) to pay your tax bill, at which point both your student loan debt is eliminated and your taxes are paid in full.


CONCLUSION: For today's medical students who borrow the full cost of private undergraduate and private medical education, defer loan payments through residency, earn an average doctor's income, and make the minimum loan payments allowable through PAYE, their expected loan payback will be a 10% tax on income for the next twenty years (which ironically is often quite close to the original loan principal!), plus taxes on the smaller of either (1) their loan forgiveness in full or (2) their net worth after forgiveness.

The twenty years of annual loan payments will always be a manageable portion of current income, and the loan forgiveness at the end, while financially painful, will not send anybody into negative net worth territory.

That last part is interesting. So if I had to deal with this, I think I would hide my wealth in precious metals like gold coins, silver, platinum, and palladium. Seems like you make out lie a bandit the poorer you are.

I'm sure there will be gaming of this system.

 

[jakeislove]

Thanks so much for clarifying this!

 

[deleted307836]

Very interesting post, sazerac. Thanks!

That last part is interesting. So if I had to deal with this, I think I would hide my wealth in precious metals like gold coins, silver, platinum, and palladium. Seems like you make out lie a bandit the poorer you are.

I'm sure there will be gaming of this system.

You'd really risk a possible jail sentence and even your career to save some money this way? I sure as hell wouldn't.

That said, there are always people who try to game the system. I won't have much sympathy for them if caught.

 

[Igor4sugry]

With physician income it should be possible if not required to pay off the loan in 10yrs. Anything longer is just not sound financial plan.

 

[kiklion]

With physician income it should be possible if not required to pay off the loan in 10yrs. Anything longer is just not sound financial plan.

Why do you say that?

If we take his example of $500,000 of debt, and earning $250,000 a year working. You will be paying ~$25,000 a year for 20 years (total of $500,000) and then a payment equal to ~35% of your total assets (assuming average tax rate of 35% on income above normal income).

Or you could try to pay it off early. If you are making $250,000 a year (with 2013 tax brackets, this is probably going to get worse) you pay a combined 26.6523% federal income tax. Another ~15% for SS/medicare/state/unemployment etc for a total take home of say, $150,000.

In order to pay off $500,000 over 10 years at 7.4% interest, you need to pay $70,908.36 per year.

Which means, two of your options are:
A: Pay $25,000 a year, live off of $125,000 a year, paying a total of $500,000 and then pay ~35% of your assets 20 years from now
B: Pay $70,908.36 a year, live off of ~$80,000 a year paying a total of $709,083.6.

Assuming you have less than $597,000 worth of assets, you would pay less over all with plan A than with plan B. If you spend about $100,000 a year on items without long term value, you would have that asset level.

If you are more of a frugal person, Plan A is definitely better as you would have more savings built up and your assets will likely top $600,000. If you plan on cruising every weekend, leasing your car, renting a home (from a family member ran business), donating money to charity etc then plan B may be cheaper overall but you would have less possible savings.

 

[dpmd]

Why do you say that?

If we take his example of $500,000 of debt, and earning $250,000 a year working. You will be paying ~$25,000 a year for 20 years (total of $500,000) and then a payment equal to ~35% of your total assets (assuming average tax rate of 35% on income above normal income).

Or you could try to pay it off early. If you are making $250,000 a year (with 2013 tax brackets, this is probably going to get worse) you pay a combined 26.6523% federal income tax. Another ~15% for SS/medicare/state/unemployment etc for a total take home of say, $150,000.

In order to pay off $500,000 over 10 years at 7.4% interest, you need to pay $70,908.36 per year.

Which means, two of your options are:
A: Pay $25,000 a year, live off of $125,000 a year, paying a total of $500,000 and then pay ~35% of your assets 20 years from now
B: Pay $70,908.36 a year, live off of ~$80,000 a year paying a total of $709,083.6.

Assuming you have less than $597,000 worth of assets, you would pay less over all with plan A than with plan B. If you spend about $100,000 a year on items without long term value, you would have that asset level.

If you are more of a frugal person, Plan A is definitely better as you would have more savings built up and your assets will likely top $600,000. If you plan on cruising every weekend, leasing your car, renting a home (from a family member ran business), donating money to charity etc then plan B may be cheaper overall but you would have less possible savings.

Your argument isn't very clear, but let me point out something. Unless you aren't planning for retirement, or you are hiding your money, you should end up with more assets than 600K after close to 20 yrs of attending pay. Hell, I am more than halfway to that already.

 

[type b pharmD]

THANK YOU, for mentioning the insolvency exclusion (IRS form 982). Nobody seems to understand this, especially the PAYE/IBR 'bears'.

How beneficial this exclusion really is to future healthcare providers depends exquisitely on how they distribute their (likely large amounts of assets) during the year(s) leading up to loan forgiveness. For a traditional family or investor who is a high income earner, (ie assuming at least 500k of assets by mid to late career), the exclusion doesnt really benefit them. For someone who is financially .. 'creative', has their taxable assets ducks in a row and a good accountant, the debt forgiveness tax hit can truly be minimized by using the insolvency exclusion.

 

[PAYE1]

Obama has proposed removing the tax bomb upon discharge in his 2014 budget and House Republicans appear to be on board. So, this discussion is likely moot.