Income-based repayment question Forum

[Anonymous User]

I recently gave the popular "pay off your loans ASAP then leave big law if you'd like" spiel to a junior who has decided they don't want to stick around for more than three years (if that many). They disagreed and said their plan is to take a much lower paying job post-biglaw and thus will save and invest as much as they can for their remaining time in the industry, rather than throw money at repayment. In short, they plan to just pay the minimum IBR amount going forward and deal with the tax bomb hit on what's left over when forgiveness comes.

I don't know much about the mechanics of IBR, but this sounds like it makes it oddly easy to skip out on proper repayment. Am I missing something?

[Anonymous User]

I know people taking this approach - their theory is that they will come out ahead paying the minimum in loans and investing the rest, then paying the tax liability down the road, rather than having to delay investing to pay off the loans. The idea is that if they’re successful financially, they’ll have the money to pay the tax bomb, and if they aren’t and have limited assets, they’ll only get taxed in relation to their solvency. I think the idea is also that their debt is significant enough that their tax burden is less than what the debt + interest would be. I haven’t run the numbers to figure out if this makes sense or not (I’m completely ignorant of this level of tax calculation and am also not taking this route), but it’s a school of thought that’s out there.

I think you have to be comfortable with a certain level of uncertainty, since tax law and repayment programs can change (you should be able to be grandfathered in to some extent, but still). I also think some of the people I know taking this approach are banking on either student loan forgiveness, or elimination of the tax bomb (I don’t think anyone’s got their debt forgiven under PAYE/REPAYE yet, so it’s pretty unclear what the typical experience is going to be).

[Trogdor]

Can someone please explain the "tax bomb"?

[1styearlateral]

The amount forgiven is treated as income. So if at the end of your repayment period you are making $200k/yr, and your total forgiveness is $200k in the aggregate, you pay taxes on $400k as income that year.

I wonder if the IRS would accept spreading out the tax bomb over two or more years (in the above scenario, $100k for two successive years) if the borrower indicates that they wouldn’t be able to pay in one lump sum.

[CanadianWolf]

It wouldn't be a "tax bomb" if the IRS permitted taxpayers to spread out income over more than one year (reminds me of the old 5 year tax averaging).

[nixy]

I don’t know that the IRS would count the tax benefit over multiple years (I agree there’s no particular reason they would, if you get forgiveness in year X, it’s part of your year X tax situation). But people regularly can’t afford to pay their taxes in one great lump so the IRS offers payment plans (IIRC they’re interest free). I’m sure that would be an option here.

[Anonymous User]

I know people taking this approach - their theory is that they will come out ahead paying the minimum in loans and investing the rest, then paying the tax liability down the road, rather than having to delay investing to pay off the loans. The idea is that if they’re successful financially, they’ll have the money to pay the tax bomb, and if they aren’t and have limited assets, they’ll only get taxed in relation to their solvency. I think the idea is also that their debt is significant enough that their tax burden is less than what the debt + interest would be. I haven’t run the numbers to figure out if this makes sense or not (I’m completely ignorant of this level of tax calculation and am also not taking this route), but it’s a school of thought that’s out there.

I think you have to be comfortable with a certain level of uncertainty, since tax law and repayment programs can change (you should be able to be grandfathered in to some extent, but still). I also think some of the people I know taking this approach are banking on either student loan forgiveness, or elimination of the tax bomb (I don’t think anyone’s got their debt forgiven under PAYE/REPAYE yet, so it’s pretty unclear what the typical experience is going to be).

OP here. Thanks for the explanation.

[sixers2020]

This is smart, I wish I had done this. I worked in big law for 3 years and am now working for the govt and pursuing PSLF on an income-based repayment plan. I threw too much money at loans in my big law years.

[1styearlateral]

I don’t know that the IRS would count the tax benefit over multiple years (I agree there’s no particular reason they would, if you get forgiveness in year X, it’s part of your year X tax situation). But people regularly can’t afford to pay their taxes in one great lump so the IRS offers payment plans (IIRC they’re interest free). I’m sure that would be an option here.

Yeah, this is what I'm wondering. At the end of the day, the IRS just wants to get paid. They're not really any different than your average creditor. I guess we'll start seeing data on this in the next 20 years or so.

FWIW, this has been my strategy so far. Rather than throwing as much money into my loans as possible, I've done the opposite. In fact, I've mainly paid interest and barely scraped into the principal. My thoughts are (a) I might make tons of money later on in life (through smart investments, etc.) and be in a position to pay them off much faster without being cash-poor (although I still might not do this, see (b)); and (b) I can start saving for the tax bomb after my loans mature, which should be less than the total balance of the loan (so long as I keep paying interest). Couple (b) with the possibility of spreading out my tax dues over several years, and it seems like a no-brainer (especially if no interest). My student loans don't seem to really affect my credit or financial well-being; I have a very high credit score and am now poking around the idea of buying a house. So far, my loans haven't been soul-crushing for me as they have for some other people, and while I don't love the idea of six figures hanging over my head, I prefer to have the liquidity to enjoy life today. I never worked biglaw so that may have shaped my decision.