The Hidden Trap of Income Based Repayment

In 2007, the Bush administration pioneered a new approach to student loan debt: income-based repayment.  The idea was that you'd pay some fraction of your income every year for 25 years, and then any balances would be forgiven . . . which is to say, the government would pay them off.  

Some version of this has been proposed for decades (usually with the idea that private equity types will buy stock in your future income).  But it's never really gone anywhere, because the moral hazard issues are obvious: you're encouraging people to run up a bunch of debt and then take a relatively low-paying job.  

But with more and more people drowning in student loans, the administration was willing to try something.  They passed IBR in 2007, and a couple of years later, the Obama administration lowered the income limits--you now only have to pay 10% of your income if you qualify.  

Is this going to cause students to load up on un-repayable debt?  Too soon to tell.  But there's one thing that's in little doubt: in about 25 years, the government is going to be on the hook for some huge loan balances, particularly for graduate professional education--architects, lawyers, vetrinarians and so forth who never hit the big time.  

But that doesn't mean that grads will be off the hook.  This sad, sad New York Times article on the plight of newly minted vetrinarians highlights an aspect I hadn't thought of: according to the New York Times, when that debt gets forgiven, the IRS will treat the forgiven principle as income, and tax you on it.

The bad news is that the interest on the debt keeps growing and taxes must be paid on the amount discharged, as if it is a gift. Dr. Schafer sends $400 a month to Sallie Mae, a sum that will rise. But what kind of tax bill awaits her? Asked to run the numbers, GL Advisor, a financial services company that specializes in student loans, calculated that Dr. Schafer’s debt is likely to exceed $650,000 when her tax bill lands 25 years after the start of the loan, which means she will owe the Internal Revenue Service roughly $200,000. That will happen while she is still deep in her career, perhaps around the time she wants to send some children to college.

There's a real possibility of a sort of anti-moral-hazard here: students may take on lots of debt, figuring they can always go into IBR, but not understanding that they'll be on the hook for an enormous tax bill.  So people may screw themselves while thinking they're screwing the government.

Of course, if this happens to enough people, I assume the government will change the rules, the way they did for the forgiven principle amount on short sales.  But I wouldn't count on it, if I were a prospective vetrinarian: in 25 years, the government may not have that kind of money lying around.