[Editor's Note: This is a guest post from regular reader Alex Heisler. Alex just recently completed his residency in 2017 and is now a practicing psychiatrist at an academic center in Baltimore, Maryland. His wife, Samantha, is a pediatrician. There is a lot of information written on this site about student loan repayment programs but Alex takes a different angle focusing on how lowering your AGI can save you big money while paying off those loans. Alex calculates that he'll be saving about $42,300 from this year's tax/loan strategy alone. Alex and I have no financial relationship.]
The purpose of this post is to demonstrate the importance of understanding the basics of your financial situation. Learning the details of our student loan repayment program and our tax situation has helped my wife and I make informed financial decisions that will save us hundreds of thousands of dollars in taxes and student loan payments.
Why We Chose Public Service Loan Forgiveness (PSLF)
My wife and I recently finished residency. She's a pediatrician and I'm a psychiatrist. We both have significant student loan debt and are in relatively low paying specialties. We also live in a high cost of living area and have 2 children. Given our ridiculously high student loan debt and our relatively low income (relative for being doctors and being in this much debt), Public Service Loan Forgiveness is an obvious choice for us for a few reasons:
- It allows us to make monthly payments based on a percentage of our discretionary income under one of three income-driven repayment plans (IBR, PAYE or REPAYE).
- Our payments under our income-driven repayment plan are far lower than what we'd pay under a standard 10-year repayment plan.
After 10 years of payments, the remaining balance is forgiven tax-free (as long as the rules of the program stay the same between now and then).
- All we have to do to qualify for this program is work for a non-profit hospital or government entity.
- Under an income-driven repayment plan, our monthly payments probably won't even cover the interest on our debt, even when we're making payments that are calculated based on our attending salaries.
How to Pay Less in Taxes and Loan Payments Pursuing PSLF
Calculate if You Should File Taxes Jointly or Separately
One downside to PSLF is that we're basically forced to file our taxes as married filing separately until our loans are forgiven. In most cases, married couples pay less in taxes when they file jointly, although that's not always the case especially with two high-income earners. Under IBR and PAYE (but not REPAYE), if you and your spouse file taxes separately your payments will be calculated using your individual adjusted gross income rather than your combined household AGI. Under IBR the borrower pays 15% of their discretionary income toward loan repayment each year. This is calculated based on the previous year's AGI.
Discretionary income is defined as anything above 150% of the poverty line. The poverty line for 2017 is $24,600 for a family of 4. So 150% of the poverty line for us is 24,600 X 1.5 = $36,900. That means if we each have an AGI of $100,000, and we file separately, we would each pay $9,465 in loan repayment each year ((100,000-36,900) x 0.15). But if we filed jointly we would each pay $24,465 ((200,000-36,900) X 0.15) each year because both of our loan payments would be calculated based on our combined household AGI, rather than our individual AGI. Unfortunately, we don't qualify for PAYE, which would allow us to pay just 10% of our discretionary income toward loan repayment. The reason why we don't qualify is that we both took out federal student loans before October 1st, 2007.
Since payments under IBR and PAYE (but not REPAYE) are capped at what you would pay under a standard 10-year repayment plan, not every 2-income couple pursuing PSLF needs to file separately. Some may have low enough debt (and/or make enough money) that their payments would be capped at the 10-year repayment plan rate regardless of how they file their taxes. For example, if a 2 physician couple with 2 kids had a student loan debt of just $50,000 each, both at 7.25%, and had an AGI of $83,860 each, they’d each be paying the maximum under the IBR plan since the calculated payment under IBR would amount to $7,044 per year (83,360-36,900) X 0.15), or $587 per month, which is equal to the estimated monthly payment for a standard 10 year repayment plan. Any additional income would not increase either of their payments at that point so they may as well file jointly. Couples in this situation may still want to pursue PSLF (even though their payments are the same as they would be under a standard 10 year repayment plan) because they can benefit from lower payments during the 3-7 years of residency and then get tax free forgiveness after just a few more years of making the full payments as attendings.
The REPAYE income-driven repayment program does not cap payments at the standard 10-year repayment plan. REPAYE also will not calculate payments off of your income alone if you're married, even if you file separately.
[Update from post author: There is an error here. Both spouse’s loans are taken into account when calculating your payments under REPAYE, IBR or PAYE. They will adjust your payment so each spouse pays an amount proportional to their share of the total loan debt. Assuming we each have an equal amount of student debt, in the example above we would each pay $12,232.50 annually (half of the $24,465 I calculated previously)
Based on this information we should actually change our repayment program. Since we would each pay an amount proportional to our share of the debt rather than being “double charged,” we’d be better off enrolling in REPAYE since paying 10% (instead of 15% under IBR) would more than make up for the fact that our payments would be calculated based on a higher AGI ($200,000 vs. $100,000), and therefore a higher discretionary income. Under REPAYE our payments would be $16,310 annually combined (200,000-36,900) X 0.10), or $8155 each.]
Utilize Tax-Deferred Retirement Accounts to Lower AGI
As mentioned earlier, payments under income-driven repayment plans are calculated based on the previous year's AGI. So anything we can do to lower our AGI will not only lower our tax bill, but it also lowers our loan payments the following year. You can lower your AGI through increasing payroll deductions (such as 401k, 457b, HSA and FSA contributions) and through above the line deductions. Below the line deductions and exemptions will obviously lower your tax bill but will not lower your AGI and therefore won’t lower student loan payments under income-driven repayment plans. [Note: A significant downside of using tax-deferred retirement accounts to lower AGI and thus IBR/PAYE/REPAYE payments is that otherwise a Roth account would be the ideal place to invest during residency. There is likely a future unknown tax cost associated with the decision to use a tax-deferred account during residency.-ed]
I also want to point out that some couples in our situation may be forced into a higher tax bracket by filing separately because they'll be phased out of certain tax credits and deductions. In our current situation, our tax bill isn't significantly affected by filing separately. But if you are forced into a higher tax bracket due to filing separately, that makes it even more important to lower your AGI.
Our marginal tax rate is roughly 35%. This includes federal, state, local and payroll taxes. As I said before, our loan payments next year will amount to 15% of our discretionary income this year. Since discretionary income is calculated using our AGI, for every dollar we are able to lower our AGI, we'll pay 35 cents less in taxes this year (our marginal tax rate) and 15 cents less in loan repayment next year.
This year we were able to lower my AGI by $46,100. $41,100 of that is through payroll deductions and the other $5,000 is due to moving expenses which is an above the line deduction. We lowered my wife’s AGI by $38,500, all of which is through payroll deductions. The payroll deductions we had available to us through our employers were 403b contributions ($18,000 each), 457b contributions ($18,000 each), dependent care FSA’s ($2,500 each) and my healthcare FSA ($2,600).
Assuming a marginal tax rate of 35% for each of us, lowering our respective AGIs by $46,100 and $38,500 lowered our tax bill by roughly $29,610 this year and lowered our loan payments by $12,690 for next year. That's a total savings of roughly $42,300. We will eventually have to pay taxes on the tax-deferred contributions but that will be at our effective tax rate in retirement, which will be much lower than our marginal tax rate during our peak earning years.
The benefits of a 403b or HSA may seem obvious to a typical reader of this blog. But I think our situation underscores the importance of understanding your financial situation and making informed decisions about your finances. We could easily have contributed $20,000 less to retirement accounts and still been above the 15-20% savings rate advocated for by WCI. But now that we know half of that money would just end up going to taxes and student loans, it seems silly to not use up all the tax-deferred space available to us.
[Editor's Note: In these situations, as a resident you are weighing the loss of Roth account benefits and a higher tax bill against lower IDR payments and thus higher PSLF amounts. It can be a difficult calculation, especially since some of the variables are unknown and cannot be known with certainty. If you need help doing it, consider hiring one of our recommended student loan advising companies. If you are NOT going for PSLF (and for any private loans you may have) you should give very serious consideration to refinancing your student loans. Recommended companies and special deals for WCI readers (i.e. get paid to do something you should do anyway) can be found here. There is a lot of money to be saved by managing your student loans well. The more you owe, the more potential benefit you could see from good decisions in this area.]
What do you think? What advice do you have for those pursuing PSLF? What strategies are you using to lower your loan payments and taxes? Comment below!