Why Tax Planning During the Coronavirus Pandemic Is Important — Especially If You’re on an IDR Plan

Tax planning is more important than ever during the coronavirus pandemic as budgets are tightening, uncertainty is increasing and people are taking a closer look at their finances.

Federal student loans are not like traditional debts. One reason is that tax filing status and marital status impact your payment when you’re on an income-driven repayment plan.

Many borrowers are able to take advantage of the CARES Act student loan payment pause and 0% interest, which has been extended multiple times from March 13, 2020 to August 30, 2023, unless courts rule on student loan relief lawsuits sooner. People who qualify for this relief need to plan ahead for when payments will resume, and people who don’t qualify need to prepare now.

When you apply for an income-driven repayment (IDR) plan, or recertify your income each year, your application will confirm your income by linking back to your most recently filed tax return to pull your adjusted gross income via the IRS data retrieval tool.

Related: To Link or Not to Link: Guide to IRS Automatic Income Sharing for Student Loans Repayments

Tax filing options if you’re on an IDR plan

If you’re married, and your spouse does not have student loan debt, then the following circumstances could apply to your tax planning:

• You file taxes jointly, so your payment will factor in your joint adjusted gross income to calculate your payment.
• You file taxes separately, so your payment will be based on your own income unless you are on REPAYE, which counts joint income regardless of how you file.
• You file taxes separately and reside in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin, so your payment will be based on a 50/50 split of your household income if filed correctly. See more notes on this below.

If you’re married, and your spouse does have student loan debt, then you’ll want to consider the following for your tax planning:

• You file taxes jointly, so your payment will factor in your joint adjusted gross income to calculate your payment and will be divided proportionally between your respective balances (e.g., if you owe $25,000 and your spouse owes $75,000, you file jointly so you will have 25% of the household monthly payment calculation, your spouse will have 75%).
• You file taxes separately, so your payments will be based on your own respective incomes unless you are on REPAYE, which counts joint income regardless of how you file and will calculate each spouse’s payment in proportion to their debt amount. Filing separately will also count the poverty line deduction for your household size twice because each of you report it separately.
• You file taxes separately and reside in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin, so your payments will be based on a 50/50 split of your household income if filed correctly and will count the poverty line deduction for your household size twice.

What to watch for when filing separately

Filing separately doesn’t change the fact that each of you are a household of a specific number. When you file jointly, your household size is applied once for you both. When you file separately, however, each of you can claim your household size.

Filing separately can be a great strategy to help reduce your monthly payment and achieve cash-flow efficiency. A few indicators to look for to help you decide if you should look into filing separately are:

1. You are on track for Public Service Loan Forgiveness (PSLF) or private-sector forgiveness and your goal is to minimize your payment as much as possible to maximize your forgiveness.
2. You and your spouse keep your finances separate and/or you alone are responsible for your student loan debt.
3. You (and your spouse) cannot afford a higher monthly payment if spousal income is factored in.
4. You want optimal payment efficiency to maximize cash flow.

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Filing taxes separately is not usual

There are very few circumstances when filing taxes separately from your spouse makes financial sense, so it’s not unusual for your certified public accountant (CPA) to raise an eyebrow if you ask about filing separately for student loan purposes.

What needs to be explained is that filing taxes together while only you have student loans on an IDR plan can raise your monthly payment significantly and throw off your student loan repayment strategy.

There is a “crossover point” to look for, meaning if the difference between filing jointly and separately costs you less than the cost savings of your monthly payment filing separately over the course of the year, then you have the green light on filing separately.

Filing separately in action:

Example 1: You live in Georgia, you make $50,000, and your spouse makes $150,000 and has no student loan debt. Filing separately costs you $1,080 in taxes, but your payment based on joint income will be $1,164, whereas based on just your own income it would be $164. That’s a monthly swing of $1,000! Filing separately would have to cost you closer to $12,000 ($1,000 × 12 months) for me to change my mind about suggesting you look into filing separately.

Example 2: You both live in Indiana, owe student loan debt and make about the same income, totaling to a household AGI of about $138,000. Your spouse owes $150,000 and you owe $35,000. Your household payment off of joint income will be about $900 total. Because you filed jointly, your loan payment calculation looks at you together: Your spouse's payment proportion will be 80%, or $720, while your payment proportion is 20%, or $180.

You make out like a bandit, but your spouse gets the short end of the stick if you both are paying your own loans. Filing separately could keep each of your payments true to your own income. In this case, you could also use the PAYE/REPAYE filing separately loophole to keep your payment at $180 and your spouse’s closer to $400 in this same scenario.

Tax planning for residents of community property states

Living in a community property state has a unique advantage when filing taxes separately from your spouse. Using the IRS tax Form 8958, the total household income is split in half, reducing the tax implication of filing separately significantly.

Traditionally, married couples file taxes jointly. There are not a lot of circumstances that make filing separately more advantageous from a tax perspective over filing taxes jointly even in community property states, so your CPA — even if familiar with community property state laws — may not know to divide income correctly if they’re not familiar with IRS Form 8958.

I see mistakes with this issue more often than not. If you get your tax return back and your community property 50/50 split was not done correctly, you need to fix it to avoid unnecessary tax costs. If you’ve been filing incorrectly, you can amend your tax returns as far back as three years to recoup any tax overpayment. Just make sure you don’t amend the most recent tax return you may need to recertify income from soon.

Filing separately in a community property state in action:

Example 1: You live in Texas, and only you owe student loan debt. You are the breadwinner for the family, making about $250,000 a year while your spouse makes about $40,000. You’re working at a nonprofit hospital and want to take advantage of PSLF as much as possible. Filing jointly, your monthly payment is $2,205, but you live in a community property state. Filing separately splits your income 50/50 and minimizes your tax liability. Your spouse’s income drags your household average income down to $145,000, making your payment $997 on PAYE — a difference of $1,208!

Example 2: You live in California. You and your spouse both have student loan debt, but theirs is almost paid off and you keep your finances separate for the most part. You are pursuing the maximum repayment period with PAYE forgiveness after 20 years. You make $45,000 but your spouse makes $120,000. Your payment if filing jointly would be $1,164 per month. When you file separately via the community property state income split, your spouse brings your income average up, but you can submit alternative documentation — such as a pay stub, offer letter or signed statement — for your income to be calculated off of so that, as long as you filed taxes separately, you can exclude your spouse's payment on PAYE. Your payment then would be just $164 per month!

Want an even lower student loan payment?

Reduce your adjusted gross income by contributing more to your pre-tax or tax-deferred savings vehicles such as:

• 401(k), 403(b), TSP, 457 or other qualified plans
• IRA, SIMPLE IRA, SEP-IRA
• Health Savings Account (HSA)

Other adjustments to income can include:

• Half of the self-employment tax
• Alimony paid, included in the recipient’s gross income
• Moving expenses only if you’re active-duty military moving due to military orders
• Early-withdrawal penalties levied by financial institutions
• School tuition, fees and student loan interest, however filing separately disallows you to take the student loan interest deduction
• Jury duty pay turned over to a filer's employer
• Some business-related expenses incurred by performing artists, teachers, fee-basis government officials and reservists

Tax planning with student loans in mind can be just as important as the repayment plan itself. With the right planning, you can achieve a higher level of financial efficiency, putting more money back in your pocket.

Keep in mind there can still be downsides to filing taxes separately that you should evaluate as well to make sure that the payment’s cost savings aren’t eroded by the potential consequences of filing separately. These are the things you could be giving up (if applicable):

• Education credits or student loan interest deduction of $2,500 — this may not be applicable to you anyway, however, if you have a modified adjusted gross income as a married couple of between $140,000 and $160,000
• More advantageous tax brackets, unless you’re in a community property state
• Child care tax credit
• Earned income tax credit
• Exclusion or credit for adoption expenses
• Ability to contribute to a Roth IRA, though you can still utilize the back-door Roth conversion method
• Ability to deduct rental property losses
• Ability to take the standard deduction if your spouse itemizes, or vice versa

Feel overwhelmed? Not sure what the best strategy is for you and your spouse? Schedule a consultation with me here for your customized student loan plan.