Student Loan Tax Bomb

The Student Loan Tax Bomb has entered our vernacular with the introduction of the Income Driven Repayment (IDR) options – IBR, PAYE and REPAYE. The tax bomb is an affectionate (not really) term for the tax liability resulting from any student loan forgiveness realized with an IDR option. In this blog post, I’ll address why this could be a good thing, how to manage & invest for this event and how delaying your investment influences both the future value and required monthly investment necessary.

I’ll approach this using a hypothetical profile:

D. Dreamin, DMD - $$$ School of Dentistry, A Private University

Dr. Dreamin graduated June 2016 with approximately $500k in student debt with a 7% average interest rate. Dr. Dreamin realizes the following AGI stream & resulting annual PAYE payment.

Dr. Dreamin has selected PAYE (not the optimal strategy as s/he did not consult with me) as her/his IDR plan. S/he remains single over the course of 20 years as too many suitors were scared-off by the debt (my attempt at humor).

Below are key PAYE data given Dr. Dreamin’s profile:

At this point, cost of loan could be defined as Total Paid Based on AGI ($287,685) + Loan Forgiveness Tax Liability ($364,926) = $652,611. And to put this into some prospective, the standard 10-year repayment would result in a $5,805/monthly payment with total cost of $696,600. But, this cost approach may not be accurate if you’re investing/saving for the tax bomb.

Tax Bomb Investing/Saving

The sage borrower will employ a strategy of investing/saving for the tax bomb to mitigate the total cost of the loan. The principal that applies here is to benefit from compound growth, generating earnings on earnings. This strategy should reduce the overall cost of the loan.

Dr. Dreamin reaches out to me and follows my counsel:

Invest immediately upon entering repayment.
Implement a 4 fund strategy, primarily in stock index funds.
Invest approximately $875/month given the projected Loan Forgiveness Tax Liability.
I also assume that these investments are in taxable accounts. Therefore, the target investment balance at year 20 should be about 20% greater, due to the taxable nature, than the projected tax liability, or $456,000 = ($364,926/(1-.20)) in this example.

Dr. Dreamin realizes a 7% annual return on investment resulting in an investment balance of $457,967.

Now, the cost of the loan can be calculated as the Total Paid Based on AGI ($287,685) + the amount invested ($210,000 = ($875/month x 240 months). Total cost of loan is $497,685, lower than the balance at repayment of $500k. The effective interest on this loan is -0.05%. Yes, a negative interest rate.

Okay, let’s assume Dr. Dreamin doesn’t follow my sage counsel and delays the tax bomb investment by 5 years (you know who you are). Dr. Dreamin’s investment period is 15 years, investing $875/month. Here’s an investment chart plotting 20 years vs 15 years:

Delaying the tax bomb investment by 5 years results in a lower investment balance of $281,467, a difference of $176,500 ($457,967 - $281,467). This projected shortfall would cause Dr. Dreamin to increase the investment from $875/month to $1,450/month to reach the investment goal of $456,000. The cost of the loan is Total Paid Based on AGI $287,685 + the amount invested $261,000 ($1,450/month x 180 months) = $548,685. The loan cost difference between 20 years vs 15 years is $51,000 ($548,685 - $497,685 = $51,000).

Takeaways

Invest early and habitually. This commitment will benefit you in other long term investments, such as retirement.
Adjusted Gross Income (AGI) is the driving variable in calculating your income driven monthly payment – manage it by utilizing tax mitigation strategies.
Keep informed – Those in income driven repayment options must keep themselves informed. It’s all too often I consult with borrowers in IBR when they should be in either PAYE or REPAYE. This subtle difference could cost the borrower $10,000s, if not $100,000s, over the life of the loan.

What say you? Please feel free to share any comments.