By: Edmund Lau, CFA
If you are new to Public Service Loan Forgiveness (“PSLF”), please be sure to read our first and second articles in this series. This is the last installment of our 3-part series for students and recent graduates considering PSLF. In this article, we will cover several key items that can help you maximize your potential savings from participating in PSLF.
Please note that the items discussed in this article should not be interpreted as financial advice and we suggest you consult with a financial advisor regarding your personal financial situation. If you are considering PSLF, please be mindful that the first loans forgiven under PSLF will not occur until at least late 2017, 10 years from the program’s date of enactment. There is no guarantee that PSLF, in its current form, will remain the same, be amended, or be canceled in the future.
Adjusted Gross Income and Why It Matters
Let’s go through an example and assume the following:
- You are a recent graduate and will earn a gross annual income of $75,000 at a non-profit.
- You have $100,000 in graduate debt at a 6.0% interest rate, and based on your loan details, you qualify for and plan to enroll in PAYE (Pay As You Earn), one of the Income Driven Repayment (“IDR”) plans, in order to take advantage of PSLF.
As you think about your monthly budget and what you can save over the next 10 years by getting your loans forgiven under PSLF, you need to consider what steps you can take to optimize your savings.
Thankfully, the Federal Government doesn’t rely on the $75,000 that you make in gross income to calculate your monthly repayment amount for your student loans. Instead, your “discretionary income” serves as the basis for how much you will repay. Your discretionary income is calculated as your Adjusted Gross Income (the IRS defines AGI as “gross income minus adjustments to income”) less 150% of the poverty guideline income based on your household size. Broadly speaking, your student loan payments under an IDR plan are a set percentage of your discretionary income, so the lower your AGI, the lower your monthly payments will be.
Below are a few of the most meaningful things you can do to lower your AGI:
- Contribute to a Health Savings Account (“HSA”). In 2016, the annual contribution limit is $3,350 for individuals and $6,750 for families. HSA contributions can be used for qualified medical expenses, such as co-pays, prescription costs, or deductibles. The great thing about HSAs is the unused balance can be rolled into the next year and accounts can be transferred from one employer to another.
- Contribute to a 403(b) or a Traditional IRA. In 2016, the annual contribution limit is $18,000 for a 403(b) and $5,500 for Traditional IRAs for individuals under 50. There are multiple reasons why contributing to a 403(b) (i.e., the 401(k) equivalent for non-profits) is hugely beneficial. It will help to not only reduce your AGI, but also save for retirement. Furthermore, if your employer offers 403(b) matching contributions, you will reap the benefits of free money from your employer.
- If married, decide whether to file separately versus jointly on your taxes. Your marital tax filing status affects your reported AGI and can drastically affect your IDR amount. Bear in mind that the benefits of filing separately versus jointly also depend on the type of IDR plan that you are enrolled in. For example, REPAYE relies on your combined income if married, regardless of tax filing status. Furthermore, there are certain marital deductions that you may lose out on if you choose to file separately rather than jointly. In general, filing separately will usually make sense if you are doing IBR or PAYE and your AGI is significantly lower than your spouse’s. You should consult with your tax advisor or compare your tax savings under both scenarios to see what makes sense for your personal financial situation.
To see the impact of how lowering your AGI can help, let’s assume that you are single and will contribute $10,000 to your 403(b) this year. Your AGI will be $65,000 ($75,000 – $10,000). The poverty income level for 2016 is $11,880 for single individuals, so you are allowed to deduct an additional $17,820 (150% x $11,880). Your discretionary income used to calculate your monthly repayment amount is $47,180 ($65,000 – $17,820). Under PAYE, your initial monthly payment would be $393 (($47,180 x 10%)/12), saving you $717 per month relative to the $1,110 that would be owed under a 10-year traditional loan repayment schedule (based on our assumed loan terms).
Here are a few other key items to remember:
- You have to be employed by a qualifying organization and make 120 monthly payments to qualify for PSLF. However, these 120 payments do not have to be consecutive. Let’s say you work for a qualifying organization for 5 years and make 60 monthly payments, before quitting to work in the private sector for 3 years. After those 3 years, you elect to rejoin another non-profit. You still would have been required to make monthly payments under PAYE throughout the last 3 years, but none of those payments would have qualified for PSLF. You still need an additional 60 qualifying payments, meaning another 5 years of employment in your current non-profit.
- If you need to reduce your employment hours for any reason (such as going part-time to take care of children), see if you can find another part-time job at a qualifying organization to hit the 30 hour per week minimum requirement necessary for PSLF qualification.
If you are married and concerned about monthly cash flows to cover rent and living expenses, but still want to make sure you are saving enough for retirement, consider forming a strategy around each spouse’s retirement contributions. For the non-PSLF spouse, ensure that his or her contributions are enough to meet the employer’s 401(k) matching policy so that no “money is left on the table.” The spouse pursuing PSLF, however, can focus maximizing his or her contributions towards retirement and health related savings accounts. This way, the family’s combined cash flows and savings will be allocated most effectively to cover daily expenses while still meeting long-term savings goals. The reduced payments under an IDR plan relative to the traditional loan repayment plan will also help to free up the family’s monthly free cash flow.
Being strategic about your AGI will help you (1) reduce your monthly student loan repayment obligations, (2) ensure that you are on track saving for retirement, and (3) increase the amount of student loan forgiveness that you will ultimately receive under PSLF. However, we caution that the items in this article are only relevant if PSLF continues in its current form and terms. Any changes to PSLF by Congress with respect to the length of required service, the amount or treatment of the outstanding debt that is forgiven, or the terms of how the repayment amounts are determined will result in different savings outcomes than those described above.
As always, if you find our articles useful, please share with others and subscribe. If you have specific question, you can leave a comment at the bottom of this page or contact us directly if you have specific questions tied to your personal situation.