If you are married and repaying student loans under a federal income-driven repayment plan, you have an important choice to make when filing your tax return: whether to file as “married filing jointly” or “married filing separately.” Choosing one over the other might lower your monthly student loan payment.
Income driven federal student loan repayment plans are plans that set a monthly payment based on your current income and family size. Payments under these plans are generally lower than payments under a Standard Repayment Plan. Depending on the plan, payments can range from 10% to 20% of your "discretionary income," which is the income left over after you pay for basic living expenses. Your loan servicer will re-set your monthly payment amount each year, based on information from your tax return.
Income driven repayment plans include the Income Contingent Plan, the Income Based Plan, and the Pay As You Earn Plan, all described in Nolo’s article What's the Difference Between Income Contingent Repayment Plans and Income Based Repayment Plans?)
Your monthly payments under an income-driven repayment plan are set each year based on the information in your federal tax return. Your loan servicer will request a copy of your tax return, look at your income, family size, and debt load, and use those factors to calculate your payment for the year.
If you file your taxes as “married filing separately,” your loan servicer will consider only your income, not your spouse’s, in calculating your monthly payments. This can have a significant effect on your monthly payment -- possibly saving you thousands of dollars.
Example. Let's take a family with two children. One spouse makes $50,000 per year and the other spouse makes $25,000 per year and owes $60,000 in federal student loans. The spouse with the student loans debtor is in the Income Contingent Repayment program (ICR). If that spouse files a tax return as married filing separately, the monthly ICR payment could be as low as $25 per month; if that same spouse files a tax return as married filing jointly, the monthly ICR payment will be around $600.
You can run your income and expense numbers and see the effects on different repayment plans with the Department of Education’s Repayment Estimator.
Be aware that there may be some disadvantages if you file as "married filing separately."
Many valuable tax credits and deductions are not available to married couples who file their federal tax return as “married filing separately.” The disallowed tax benefits include:
There may be other tax benefits, and other public benefits, that are disallowed for those filing “married filing separately.” Most of the tax benefits listed are only available for families with lower incomes. For example, families earning more than $51,000 are generally ineligible for the Earned Income Tax Credit.
It may be worth having your tax preparer run your tax filing as both “married filing separately” and “married filing jointly” to see the difference in your tax bill. Remember, income-driven repayment plans require repayment for 20 to 25 years, so the tax effects will apply for decades.
One other trade-off from making lower payments in an income-driven repayment plan is the likelihood that you will have a larger forgiven loan balance at the end of the repayment period. Forgiven student loan debt may be considered income on your tax return. this means that you may end up with a sizeable tax bill in the year your balance is forgiven. For example, for the family described above, $110,000 in debt will be forgiven after 25 years of monthly payments (assuming income does not change significantly). Assuming a low 15% tax rate, this still will result in an additional $16,500 in taxes owed that year.
Taxes on forgiven debt are not an issue for people repaying student loans under the 10-year Public Service Loan Forgiveness program--any balance left after ten years of payments is forgiven without a tax penalty. Some other career-specific loan repayment programs have the same terms. Check with your loan servicer to see if you qualify for one of those programs. In addition, as of 2014, Congress was considering changing the law to make all forgiven student loan balances non-taxable.