Something Borrowed Makes You Blue - Student Debt And Joint Returns

This post was originally published on Forbes Jul 5, 2015

The joy over the Supreme Court's decision in Obergeffel et al v Hodges, Director, Ohio Department of Health should not obscure an important point, which I addressed in one of my earliest posts - Just Because They Won't Let You Do it Doesn't Make it a Good Idea.  Marriage is not an unmitigated financial blessing, particularly when it comes to taxation.  So now Professor Victoria J. Haneman will be pointing out another downside in an unreleased article The Collision of Student Loan Debt and Joint Marital Taxation.

Professor Haneman has dived into the student debt issue starting with an article last year suggesting that the policy rationale behind the student loan interest deduction was less than compelling.  Not having a dog in that fight either personally or as a planner, I won't express an opinion, but I will say that she makes a good case and the article is thought provoking.

Favoring student loan debt through a student loan deduction, in combination with unqualified access to borrowed funds, is nothing more than the congressional recycling of policies applied in the context of home mortgage borrowing. Unlike mortgage debt however, all student loan debt (including debt borrowed from private, for-profit lenders)falls within a very narrow category of debt that is nondischargeable in bankruptcy

Income Based Repayment And Other Ways To Kick The Can Down The Road

The collision of student loan debt and joint marital taxation relates to programs that have been designed to help debtors avoid default.

The best-known program, which is not saying much, is probably Income Based Repayment, but there is also Pay As You Earn.  I'm not going to discuss the details as to which particular loans qualify for which program.  I'm just going to give you the essence.  The essence of the programs is that you are allowed to make a monthly payment that is keyed to your prior year's adjusted gross income rather than a payment that would amortize principal and interest over a ten-year period.  If the payment does not cover the interest, the government might subsidize you for three years, but after that the loan balance will start growing and on some loans there is no subsidy.

I first learned about IBR back in 2011 when I noted that excessive student loan debt was one of the main grievances being addressed by the Occupy movement.  My post on it sparked some heated comments.  My one conclusion is that IBR is probably better than default, which can have dire consequences, but it also did not seem like a panacea.

In some ways  it is really hard to get excited about the program as being a big help.  It's like reducing the minimum payment on your credit card.  If your IBR payment does not cover the interest, you are, in effect borrowing more money and as my first managing partner, Herb Cohan, used to say "You'll never get out of debt by borrowing".

There is another wrinkle.  If you dutifully make the required payments, which conceivably could be as low as zero, your loan balance will be forgiven after twenty or twenty-five years.  That is where things get interesting, particularly for people with graduate degrees, who can have very large student loan balances. Professor Haneman told me that some schools are helping their students explicitly plan to maximize ultimate loan forgiveness by managing their adjusted gross income and thereby maximizing loan forgiveness.

Georgetown Law could be an example of a school promoting that type of planning.  Here is a clip from one of their seminars, where graduates are urged to minimize adjusted gross income.

As I poked around, I found other examples like this post by Rachel Rowan How to Reduce Your AGI to Get the Most from Income Based Repayment.

Joint Returns

A couple who goes from two single returns to married filing jointly may end up with either a greater or lesser aggregate tax.  Generally the rate tables will favor those whose income is unequal, but there are a lot of other factors.  Going from married filing jointly to married filing separately will often result in a greater aggregate tax and almost never in a lower tax.  It is still a choice that I encourage people to consider, because of the really big downside of joint filing - joint and several liability.  If full payment is not going in with the joint return or one-half of the couple's numbers are on the sketchy side, the IRS collection people can pursue both halves of the couple.

We now have a situation where married couples might come out ahead by filing separately.  The AGI used to determine required payments under IBR and Pay As You Earn is the couple's joint income if they file jointly and the separate income of the debtor spouse if they file separately (Forgive me, but I am going to ignore community property states, which give me a headache).   To take an extreme example consider Robin and Terry.  Robin is entrepreneurial and manages to have a substantial income with no student debt.  Terry has a Ph.D and a commensurate amount of debt and works off and on as an adjunct professor.

If Robin and Terry file jointly, Terry has to make full payment on the student loans.  If Terry files separately no student loan payments are required.  President Obama's 2016 budget proposal would change that.  Professor Haneman tends to think that the existing option to treat the student loan debts of couples separately is more consistent with contemporary views of marriage.

I believe that allowing a borrower to qualify for income-based repayment and loan forgiveness on the basis of income stated on a separately filed tax return represents a step towards a contemporary model of marriage—in which two individuals, rather than being merged into a single indivisible unit, are instead treated as each retaining their own economic identity. It was the intent of Congress that student loan borrowing be marriage neutral, and that a borrower's payments under the income-based repayment plans not increase purely based upon the fact of marriage. 

While the long-term effects of such a change remain to be seen, I believe that it will serve as an assault upon the institution of marriage to require married borrowers to include their spouse’s income in the income-based payment calculation . Data suggests that the younger generations are already deeply divided on the role of marriage in modern society.  We may see this change to student loan policy causing borrowers to buck traditional norms in favor of more modern arrangements (e.g. cohabitation over marriage).

Then There Is The Debt Bomb

Since Income Based Repayment is a relatively new program and Pay As You Earn is even newer, nobody has had any debt forgiven under either program.  The first flurry of debt forgiveness will be in 2017 for people who have held public service jobs.  Let's pass them by and think about those for whom debt forgiveness is still well over a decade away.  The prospect already has people worried and the worry comes from Code Section 108, which concerns the taxation of income from debt discharge.  Code Section 108(f) exempts some student loan debt discharge.

if such discharge was pursuant to a provision of such loan under which all or part of the indebtedness of the individual would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of employers.

That may be a lot of people, but it is clearly not everybody.  So let's consider Terry who we will assume started out with $100,000 and never paid anything.  Rather than seek false precision with an Excel spreadsheet, let's go with an interest rate in the 6% vicinity and use the rule of 72, which tells us that Terry's debt will roughly double twice in a quarter century.  So Terry in, let's say 2035, may owe more in federal income tax from discharging the debt than the original debt.

Ron Lieber of the New York Times wrote about this prospect in 2012.  Missing from much of the discussion on this topic is a peculiarity of Section 108.  Income from any sort of debt discharge is only taxable to the extent that it makes you solvent. So if Robin and Terry are really clever (and love and trust one another very much), the couple's assets will be with Robin. (Robin and Terry can move about the country, but should avoid community property states.) Terry will file separately in 2035.  The $400,000 debt discharge will bring Terry's net worth to zero, making none of it taxable.

Does This Make Any Sense?

Whether this makes any sense is actually a two part question. The first part of the question is whether the type of planning that is being suggested to young professionals to minimize AGI to minimize current payments and thereby maximize the part of the loan that never has to be repaid actually makes sense. If the prospect of ultimate discharge was not there, the question of whether deferring student debt versus putting money in a retirement accounts, for example, boils down to one of returns.

If a thirty-something asks the typical financial advisor whether a debt pay down is better than a retirement contribution, the advisor will probably go with the retirement contribution, probably sincerely, but you have to remember getting yourself debt free does not generate assets under management for anybody.  For somebody whose interest rate is much over 4%, I'd lean towards debt repayment, since the interest savings is a sure thing.  I'm pretty risk averse, though, which, in part accounts for me not being really rich.  The risk aversion also accounts for me being not poor. My initial investment program after flunking out of graduate school was paying off my student debt, a laughably small amount by today's standards, as quickly as possible. 

From a policy point of view, the current system, if you can call it that, makes no sense at all.  The message graduate schools can now send to a highly indebted student is that further increases in debt never have to be paid back, so there is no point in being price conscious.  It is as if we have consigned an entire generation to be in a permanent state of work-out.

Some Thoughts From An Activist

Allan Collinge is the founder of StudentLoanJustice.Org. I became acquainted with Allan during Occupy.  His view is that the first step in solving the student loan crisis is to apply the free-market consumer protections applicable to most other debt, including bankruptcy relief, to student debt.  His analysis of Income Based Repayment is scathing.

1.  The Department of Education has no desire or intentions of making good on the forgiveness through this, or any other repayment programs (including the public service loan forgiveness program), and will use every tool to kick as many borrowers out of the program as possible.  This will leave them, usually, owing far, far more than when they entered.  Getting married, and the joint income that comes with it is only one of many mechanisms the Department will use to thin out the borrowers prior to having to forgive the debt.  Credit card teasers enjoy a miniscule 15% success rate.  I suspect the results for IBR won't be much different from this, but the stakes are much, much higher. 

2.  Those lucky few who DO make it through the end of the repayment term with IBR will be hit with a MASSIVE tax burden based upon the amount forgiven (which could be many times the amount they owed when they entered the program).  For these people the tax liability alone would make the entire process a wash, at best, financially.

My Own Two And A Half Cents

In then end, I tend to think that graduates should be informed about IBR and similar programs, but I suspect that their best application is to avoid default not to stretch the debt out for ultimate forgiveness.  I think public policy would be best directed toward figuring out how to make higher education less expensive and perhaps reverse the long-term trend to greater and greater credentialling.

Frankly, I think that anybody who can pass the CPA exam should be able to be licensed as a CPA, which is how it was back in the day.  That principle would not apply to more hands-on professions like medicine, but perhaps much of the classroom piece could be foregone by those who can learn other ways.  Certainly liberal arts education, which when you get down to it involves a lot of reading of books which are now available for free, should be a lot less expensive.  I'm not really optimistic about any of that, but I can dream of a return to the days when a summer of hard work in a valve factory could earn a year's tuition at a not too shabby liberal arts college.