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Bar News - November 19, 2014

Traps Hidden in Federal Student Loan Forgiveness Programs


This past summer, individuals with outstanding student loan debt, including young lawyers everywhere, rejoiced when President Barack Obama dramatically expanded the sphere of those who may participate in the “Pay As You Earn” program (PAYE).

PAYE allows individuals with federal student loans to: (1) make payments based upon a percentage of their income (around 10 percent); (2) extend their payment period (from 10 years to 20 years); and (3) obtain forgiveness of the balance of their loans after a certain time period (10 years for public interest jobs, and 20 years for the private sector).

PAYE and similar programs are responses to a growing concern – the increasing debt saddling millions of Americans. The average student now leaves school $30,000 in debt ($33,000 in New Hampshire). If you want a graduate degree, try $60,000 on for size. And, the average professional now graduates with more than $100,000 in student loan debt.

For many borrowers, PAYE seems like the simple solution – pay only what you can comfortably afford; extend the plan over several more years; and if you don’t get around to paying it off, it disappears.

Not so fast.

While PAYE may benefit some strapped borrowers, the law contains dangerous traps for the unwary. Chief among them is the “tax trap.” This trap springs on those least equipped to handle it; those individuals who obtain loan forgiveness after 20 years, many of whom continue to struggle to make payments throughout the life of the loan. For these borrowers, when the loan agencies disappear, the IRS comes knocking. This is because every penny that is forgiven under PAYE will become taxable and included in the borrower’s income in the year it is forgiven.

Take the example of the average professional graduate. Let’s call him “Joe.” Joe graduates from law school with $100,000 in federal student loan debt, and his interest rate is 6.8 percent (a common rate). The standard repayment option over 10 years is roughly $1,150 per month. Even with a standard extended 20-year repayment schedule, Joe will be required to pay $765 per month. These numbers can seem daunting to any new graduate.

Now, add PAYE to the mix. Let’s say Joe makes an average starting salary of $55,000 (typical of smaller firms in the state, when they are hiring). Under PAYE, he would be required to pay only around $310 per month.

Here is where PAYE starts to present a problem and not a solution for Joe. While Joe’s payments are reduced, freeing up funds for other things (new car, nicer apartment, etc.), Joe is not even paying his interest charges ($516 per month). Thus, while he pays a bargain amount, his loan continues growing, and does so quickly, making it more difficult to eventually get a handle on the loan and pay it off.

If Joe continues to pursue this option, he may look to, or ultimately need to, depend on the 20-year loan forgiveness. And, if Joe fails to repay $20,000, $30,000, or even $50,000, on the outstanding balance, the remaining amount is added to his gross income and taxed by the federal government when it is forgiven. His old, outstanding loan debt has simply been replaced by a shiny new tax bill, owed immediately to the IRS, an agency generally considered anything but forgiving.

While Joe’s situation may appear unlikely, it is not. With unemployment still relatively high and wages almost stagnant, and with colleges and law schools increasing tuition yearly, student borrowing continues to skyrocket, and paying the bare minimum on loans has become the norm.

What is perhaps scarier is that no one seems to know the tax trap exists. I have discussed this issue with countless friends, colleagues, even my barber, most of whom are borrowers of student loans, some with grand plans for loan forgiveness, and just about all blissfully unaware of the “tax trap.”

Ultimately, PAYE and similar programs might benefit some people. In fact, the public interest loan forgiveness, which is exempted from taxable income when forgiven, presents as a sound option for many (so long as Congress does not institute the “Forgiveness Cap,” as many members have indicated they will try to do).

But it’s important to understand that these programs are not right for everyone. All borrowers, especially high-debt professional borrowers, should read the fine print and make an informed decision before hopping on the PAYE train or relying on 20-year loan forgiveness.

Bryan Townsend II

Bryan Townsend II is a lawyer at Gottesman & Hollis in Nashua.

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