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?
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!