Student loan repayment and the ethics of personal finance

[This is the third installment in a series examining repaying student loans. Part I was a best practices guide for repaying student loans. Part II discussed an alternative payment plan, Revised Pay As You Earn or REPAYE.]

In my last post on REPAYE, the new student loan repayment program, I mentioned that it might be possible to artificially lower your adjusted gross income (AGI) in order to lower your required monthly payments under REPAYE.

Similarly, it may be possible to lower your AGI to qualify for Income-Based Repayment (IBR) or Pay As You Earn (PAYE) since, unlike REPAYE, those plans require a partial financial hardship in order to participate.

Your AGI is listed on your federal income tax return and is the number used to determine eligibility for income-driven repayment plans. The lower your AGI, the lower the monthly payment that is due under these types of plans.

There’s a lot to unpack in the previous paragraphs, so let’s get started, shall we?

How is Adjusted Gross Income (AGI) Determined?

Young student pondering

AGI is determined by taking your total gross income (that is to say, all income from all sources) and subtracting specific deductions.

While that’s not too specific, here’s a rule of thumb: Generally speaking, things you pay for with pre-tax money will lower your AGI. It’s not always the case, but close enough for government work.

How Can I Lower My AGI?

You can’t control all of your pre-tax spending. The cost of things like health insurance premiums (if you’re on an employer’s plan), alimony payments, and so on, may be out of your control. However, there are three big categories of pre-tax spending that you may be able to manipulate to one degree or another: pre-tax retirement contributions, HSA contributions, and student loan interest paid.

1. Pre-tax retirement contributions
Contributions to retirement vehicles like traditional 401(k), 403(b), 457, and Thrift Savings Plans are made with pre-tax dollars. That means it doesn’t count as income today and, instead, is income you will receive — and pay taxes on — later. The 2015 pre-tax contribution limit for these plans is $18,000; so if you have access to one of these plans, you can lower your income significantly. This not only decreases your student loan payments if you are on an income-driven plan, it decreases your overall federal income tax burden.

If you are eligible, you may be able to lower your AGI even further by contributing to a traditional IRA (Roth IRA’s are paid for with post-tax money, so they don’t lower your AGI). If you are self-employed, you may be able to use SEP IRA contributions to lower your AGI.

2. Health savings account contributions
Individuals enrolled in high-deductible health plans (HDHP) may open health savings accounts (HSAs) with pre-tax dollars. Funds contributed to HSAs roll over from year to year, although you must use them for qualified medical expenses or face a penalty. The 2015 contribution limit for an individual HSA holder is $3,350. That’s another significant chunk off your AGI!

Although people with children and/or pre-existing medical conditions tend not to prefer these plans, they are popular with young adults who assume they’re invincible and are attracted to the idea of no or very low monthly premiums. And hey, what do you know? That is also the precise category of individual likely to have significant student loan debt and benefit from lowering AGI to qualify for reduced student loan payments on an IDR plan.

3. Student loan interest paid
As mentioned in my previous article, student loan interest paid is an above-the-line deduction, which means it lowers your AGI. In 2015, the maximum amount of student loan interest you can deduct in this manner is $2,500. While your eligibility for this deduction phases out at a certain income threshold, deducting your student loan interest paid if you are able will, ironically, lower your AGI and help you qualify for lowered monthly payments in the subsequent tax year.

Also ironically, under many IDR plans your entire monthly payment may be going toward interest (indeed, your monthly payment might not even cover the interest accruing). In other words, being on an IDR plan increases the likelihood that you’ll pay the maximum amount of deductible student loan interest in the first place. A nice little feedback loop, that.

Is it ethical to artificially lower my AGI to qualify for an income-driven repayment plan?

Ultimately, it is up to you to decide your ethical standards and what financial responsibility means to you. Some people believe that paying back your debts as quickly as possible is important, even if you incur some financial hardship in the short term. Others will point out that as long as you qualify for them, all of these deductions are perfectly legal.

Is there morality in personal finance? After all, high-income earners and high-net-worth individuals employ financial professionals specifically to minimize the amount of taxes they pay and maximize the value of their investments. If you’re in debt because of your degree and aren’t yet earning a lot, aren’t you entitled to do the same? And as long as you’re abiding by the repayment terms outlined, it’s unclear to me how someone could accuse you of immoral behavior — or for that matter, why you should care if they did.

Do what works for you, I say. If you employ every AGI-lowering strategy at your disposal and still qualify for IBR or PAYE, you are hardly living high on the hog. And if you opt for REPAYE, you could end up making monthly payments that are higher than the standard repayment amount.

Is it smart to artificially lower my AGI to qualify for an income-driven repayment plan?

Now this is a totally different question than above! Instead of pondering existential questions of morality, you need to ponder existential questions of risk tolerance.

Pros of lowering AGI to qualify for lower payments under an IDR plan:

  • Max out pre-tax retirement vehicles early in your career, allowing compound interest to work its magic.
  • Save for future medical expenses in an HSA.
  • Lower student loan payments frees up money in the short-term for other expenses or goals (such as having children, putting a down payment on a house, buying a newer and more reliable vehicle, etc.)

Cons of lowering AGI to qualify for lower payments under an IDR plan:

  • Possible negative psychological impact of making 20 to 25 years of repayments on a potentially increasing balance.
  • Potentially massive tax bill when outstanding balance is forgiven at the end of the term.
  • Tie up funds in retirement accounts that can’t be accessed without penalty until age 59 (and a half) rather than a high-yield online savings account that can be used in case of an emergency.
  • Putting off milestones such as marriage in order to optimize your student-loan-repayment situation.

[Note: I am not a tax or student loan professional. Consult a tax professional and/or the Federal Student Aid website and/or your student loan servicer(s) before deciding what repayment plan is the best fit for you.]

Do you think it’s ethical to use tax-advantaged savings vehicles to lower your AGI and thus your student loan payments on income-driven plans like REPAYE? What pros and cons am I missing? Share your comments below!

More about...Debt, Taxes

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There are 12 comments to "Student loan repayment and the ethics of personal finance".

  1. Beth says 16 November 2015 at 05:52

    As far as I’m concerned, the rate at which people pay back their loans is their own business so long as it doesn’t hurt anyone else and no one else ends up on the hook for it. The longer it takes you to pay it back, the more interest you end up paying so it’s not like the advantage is all yours.

    But I have to wonder about the ethics of a system where people can take on so much student debt it could take them 20-25 years to pay it off.

  2. Carol says 16 November 2015 at 09:15

    There is nothing ethically questionable about contributing to FSAs, HSAs, 401Ks, etc. It would be different if you asked to be paid in unreported cash.

  3. Karthigan Srinivasan @ StretchADime says 16 November 2015 at 09:33

    I don’t see anything wrong ethically or morally in contributing towards 401k, HSA, or FSAs. If your income allows you to make higher payments, by all means payoff your loan as quickly as possible. There is no point in making interest payments and carrying the burden of college debt for an extended period of time.

  4. Ross Williams says 16 November 2015 at 14:36

    I think we should be clear that anything you save on your taxes somebody else pays in higher taxes. Taxes are like sharing the bill at a restaurant.You can lower the bill by buying less food, but somebody has to pay every dime of the final cost. If someone pays less than their share, someone else has to pay more than their share.

    That said, I don’t think there’s anything wrong with taking every deduction you’re entitled to. We have codified the way in which we share the bill. It’s a collective decision, not an individual one.

    • Eileen says 18 November 2015 at 11:50

      How are my taxes affected by your tax return? I understand that you are saying the government has budgets that would remain the same regardless of if someone pays less (or at all), but my taxes don’t go up because my neighbor pays less.

      They could lose their job, a spouse could stop working, they could change their finances in order to put more toward pre-tax savings, they could have their health insurance premiums rise.

      When my kids were little, we saved money and I took about 18 months off. Our income went down dramatically and we paid WAY less income tax. No one’s taxes went up because of that personal decision.

      • Ross Williams says 18 November 2015 at 12:16

        I think you misunderstand. It may be that my taxes won’t go up. That depends on how we reallocate the costs. For instance, if the government borrows money the bill will be paid by future taxpayers.But someone pays the bill eventually.

  5. Tonya says 16 November 2015 at 20:58

    I don’t know about everyone else’s income, but I can barely pay all my bills and contribute a tiny amount to my 401(k) every month. Getting my income so low I’d qualify for reduced loan payments would leave me without the cash I need for living expenses. I say if you can figure out a way to do it and still pay your bills, you deserve a break on those student loans!

  6. Rob says 20 November 2015 at 08:40

    I have a different scenario for the whole ethics thing. My wife’s and my student loan payments are currently $0 through IBR (I work in a non profit and my wife works part time and we have a child, so our AGI is low). I can qualify for a non-profit forgiveness in a few years, and unless our income drastically changes, my wife’s payment will continue to be $0 until she reaches the 25 year IBR forgiveness.

    So the ethical question for us: It’s very possible that we’ll never end up having to pay any more on our loans. We both have master’s and bachelor’s degrees from expensive private colleges, so we owe around $80K. Is it ethical to not end up paying that, even though we did it by playing fairly within IBR’s rules?

    • Rob says 20 November 2015 at 08:43

      Oops, forgot to click the “notify me of follow up…” box. Hopefully this will fix that.

    • Louise says 21 November 2015 at 09:11

      Rob: It is absolutely ethical if you followed the rules. You and your work has been determined to be valuable, (and I suspect, not highly paid). Why deny the benefit you are getting from your labor?
      Let’s say you make much more money than you need for retirement. Should you leave the social security and medicare you paid for on the table and never collect it?
      If you make donations to a charitable organization, should you skip taking tax credits for it?
      If you feel somehow guilty about working within the student loan system, someday up your donations to your alma maters to help out other students, or pick another place to give that’s important to you and your family.
      Maybe enter into general conversations with co-workers about the value of all your work and benefits at a non-profit. Look at the people in our society who are supposed to live primarily on the joy of their service and consider whether that is fair. Why can’t someone doing something good for society also be well-compensated for it?

  7. Stephanie says 20 November 2015 at 11:46

    Question to the readers (I haven’t been able to find clear info on this) – I know contributions to a traditional IRA reduce one’s AGI (per section 62 of the Code) but do contributions to a 401(k) reduce one’s AGI, or do they simply reduce one’s taxable income (meaning they would have no impact on income-based-repayment calcs)?

    • Tim says 30 November 2015 at 12:20

      Traditional 401(k) contributions reduce your AGI just as traditional IRA contributions do. The big difference is how they look on your tax return. Your gross wage/salary income shown on your W-2 form has already had the 401(k) contributions subtracted out, so there is no “deduction” on your tax return because the amount wasn’t originally included in your W-2 income to begin with. For the IRA, though, you show a deduction on your tax return because your employer does not subtract your IRA contributions from your W-2 income (IRAs are not employer-sponsored plans so the employer would have no way of knowing how much, if any, you contributed to an IRA during the year).

      In summary: 401(k) contributions are not taxed because they are never even included in your salary/wage income. IRA contributions are not taxed because they are deducted from your income on your tax return.

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