This definition is used when calculating payments under the income-based repayment plan (IBR), pay-as-you-earn repayment plan (PAYE), and revised pay-as-you-earn repayment plan (REPAYE). First, discretionary income is determined. Then it is multiplied by either 10 percent or 15 percent, depending on which repayment plan is selected. Finally, it is divided by 12 to arrive at the borrower’s monthly payment.
Repayment Plans and Loan Forgiveness
Income-driven repayment plans allow for loan payments to better align with a borrower’s ability to pay rather than a traditional amortized loan, with which most consumers and financial planners are familiar. The case scenarios presented in this paper used PAYE as the income-driven repayment plan because it provides the greatest benefits for new loan borrowers and is very flexible for planning purposes. For example, even if the borrower gets married, his or her income can be isolated for discretionary income calculations based on tax filing status.3
Under PAYE, the monthly payment will be capped at the standard repayment amount regardless of how high the borrower’s annual income grows. The borrower must demonstrate that he or she has a partial financial hardship to enroll in this repayment plan in the first place. A borrower can demonstrate partial financial hardship if the previously mentioned calculation produces a monthly payment figure that is less than what the payment would be under the standard, 10-year repayment plan. If any balance remains (comprised of principal and potentially unpaid accrued interest) at the end of the 20-year repayment term, it will be forgiven and subject to taxation the same way cancellation of debt is treated as taxable income.
In addition to the various income-driven repayment plans, numerous forgiveness programs are also available for federal student loan borrowers, such as the Teacher Loan Forgiveness Program and the Public Service Loan Forgiveness Program (PSLF). Under PSLF, a borrower may be eligible to have his or her remaining loan balance forgiven after making 120 qualifying monthly payments while meeting the applicable criteria, such as working for a qualifying public service organization, making payments on eligible loans while employed by a qualifying public service organization, and making payments under an eligible repayment plan while employed by a qualifying public service organization. The loan forgiveness is currently tax-free, and there is no limit to how much debt may be forgiven; however, it is important to note that only a small fraction of borrowers have been accepted under the PSLF program to date.4
The Role of Employers
While many programs are available for federal student loan borrowers on both the payment and forgiveness spectrums, employers are taking actions to help reduce student debt balances and to attract and retain employees.
Although only 4 percent of companies currently offer a student loan repayment assistance program, more companies are starting to offer this type of employee benefit.5 Eighty-six percent of young workers with student loans said they would stay at their current place of employment for five years if the employer would help pay off their student loans, according to a 2017 survey by American Student Assistance.6
If offered the chance to receive an extra $200 per month in benefits from their employer, 45 percent of employees surveyed by management consulting firm Oliver Wyman stated that they would prefer their employer make payments on their student loans, compared to 29 percent who would want help saving for retirement.7
Table 1 highlights 20 employers (and the U.S. government) that offer this type of employee benefit along with how much they will contribute annually, how much they will contribute in total, and what types of student loans are eligible to be paid by the employer.
Potential Issues with Employer-Provided Assistance
As shown in Table 1, excluding the assistance provided by certain U.S. government agencies, the average monthly assistance is $141 ($1,656 annually), which is designed to directly reduce the principal balance of the employee’s student loans. However, both borrowers and financial planners should be aware that although the intention of the employer is to help reduce the principal balance on these loans, it is possible that the loan servicers may not apply the additional monthly payment this way.
Loan payments are allocated in the following order under the standard repayment plan: (1) outstanding fees; (2) outstanding accrued interest; and (3) principal (applied first to outstanding accrued interest, then to outstanding fees under IBR and PAYE repayment plans). Any additional payments automatically carry forward to the next month’s payment unless a written request is submitted instructing the servicer to apply the additional payment to reduce the principal balance of the loan. So, although it may be the employer’s intention to reduce the principal balance of the loans, for borrowers who have unpaid interest (potentially those on an income-driven repayment plan), this may not actually happen.
It is also possible that when a borrower makes an additional payment with the help of their employer, he or she will be placed in “paid ahead status.” Payments made while in paid ahead status to satisfy the monthly loan obligation are not counted as qualifying payments for income-driven repayment plans or in accordance with public service loan forgiveness rules.
For example, if the required monthly payment due for Mike on his federal student loans is $100, and the employer were to make a payment of $141 without instructing the excess payment to be applied directly to principal, the additional $41 would apply to the next month’s payment. When Mike goes to pay the remaining $59 the next month to remain current in his repayment status, the $59 would not be considered a qualifying payment for the aforementioned repayment programs. Employers should make sure their plans are set up to ensure these instructions are accurately communicated to the applicable loan servicers.
This paper examined the effectiveness of this employer assistance for borrowers who may carry higher-than-average loan balances and who may be participating or plan to participate in an income-driven repayment plan. In the example cases presented in this paper, the debt-to-income ratio put the borrower in a position where he or she demonstrated a partial financial hardship and was likely to qualify for at least partial loan forgiveness at the end of the 20-year term under the PAYE repayment plan. The effects of this type of assistance, if the borrower is planning on being eligible for public service loan forgiveness in the future, were also examined.
Background and Previous Research
Although many consumer-based articles about student debt and various repayment plans available for federal loan borrowers have been published, academic research evaluating income-driven repayment plans is scarce. This is likely because most federal student loan borrowers are enrolled in the standard 10-year repayment plan and the income-driven repayment plans have not been in existence long enough to evaluate the effects or consequences of loan forgiveness.
Canché (2017) addressed the question whether students should be advised to repay loan debt as soon as possible and found that doing so would seem to have advantages, such as being more likely to attain higher annual earnings and a positive credit history in good standing. But this was only in circumstances where the borrower did not enroll in graduate school and had an average cumulative undergraduate debt balance below $15,000. Canché also noted that participants with higher loan balances may benefit more by not repaying as quickly and would be better served using the standard 10-year repayment plan; however, no analysis of income-driven repayment plans was provided in this study.
Previous studies have focused on the impact of student loan defaults and policy recommendations. Asher, Cheng, and Thompson (2014) considered whether income-driven repayment plans should be mandatory or could be re-designed to better serve students, borrowers in repayment, families of students and borrowers, and taxpayers. While Asher et al. noted that income-driven repayment plans that reduce monthly payments for borrowers—particularly lower-income borrowers—should reduce loan default rates, they also suggested that some borrowers with high incomes and high debt balances would pay less than they could have afforded to when considering the receipt of substantial loan forgiveness at the end of the repayment period.
In a study related to the effects of income-driven repayment plans on default and consumption, Herbst (2018) found that borrowers who enrolled in an income-driven repayment plan were 21 percent less likely to fall delinquent, compared to borrowers who remained on standard repayment plans. He suggested that enrolling in an income-driven repayment plan improved borrower welfare.
Abraham, Filiz-Ozbay, Ozbay, and Turner (2018a) provided insight into the repayment plan decisions made by students based on how each plan is “framed.” When the insurance aspects were emphasized, such as the lowering of payments in conjunction with lower-earning careers or periods of unemployment, student borrowers were more likely to choose an income-driven repayment plan. When the longer repayment period and higher amounts of interest were emphasized, student borrowers were less likely to choose an income-driven repayment plan.
Conzelmann, Lacy, and Smith (2018) noted that borrower complaints regarding income-driven repayment plans comprised 20 percent of all complaints filed by the federal department’s loan servicers, and that borrowers enrolled in an income-driven repayment plan took much longer to pay down any loan balance, compared to borrowers not enrolled in an income-driven repayment plan. They also noted that tying monthly payments to income reduced a borrower’s incentives to repay principal and interest due to the forgiveness provisions. Conzelmann et al. used an event history analysis to account for timing differences in the repayments of loans, which had been absent from previous studies.
Abraham, Filiz-Ozbay, Ozbay, and Turner (2018b) also found that higher-paying and riskier jobs made income-driven repayment plans more attractive to borrowers. They found that the set of repayment plans available can affect career choices, and that regret in decision-making diminished once uncertainty was resolved.
This paper expands on the prior research and makes an original contribution that analyzes employer-provided student loan repayment assistance programs to determine their overall effectiveness for federal student loan borrowers.
Tax Implications of Employer-Provided Assistance
Currently, funds provided by an employer to help an employee pay down student loan debt does not fall under the provisions of IRC Section 127, because such funds do not meet the definition of educational assistance.8 Although the payments would be tax deductible by employers, they would not be tax-free to employees (up to $5,250 annually under an IRC Section 127 Plan);9 therefore, the value of this assistance would be included as taxable income on the employee’s W-2 for each year it is received and would increase the employee’s federal and state tax liabilities and the net present value (NPV) of cash outflows (loan and tax liability payments) and cash inflows (investment contributions and returns). This can be seen in the calculations provided.
NPV is used to determine the optimal application for employer-provided student loan repayment assistance in each scenario given the timing of cash outflows and cash inflows. The three options are the borrower can: (1) decline receiving assistance; (2) have the assistance applied to their federal student loans; or (3) negotiate to receive the assistance and invest it. The option within each scenario that produces the lowest NPV and the highest future value of invested additional compensation or loan payment figures would be the best choice for the borrower to consider. This is because a lower NPV figure represents lower loan costs, and a higher future value figure associated with the investments represents more wealth the borrower would be able to accumulate over the repayment term.
Four case scenarios were used to demonstrate how effective or ineffective an employer’s student loan repayment assistance would be for single borrowers with different levels of income and debt under both the standard 10-year repayment plan and an income-driven repayment plan (PAYE).
Scenario 1: Moderate Income; Average Loan Balance; Standard Repayment
The first scenario, as seen in Table 2, considered a borrower with an annual income of $50,000 and $39,400 of federal direct unsubsidized loans with an average interest rate of 6 percent. Under the standard repayment plan, the monthly payment would be $437, the loan would be paid off in 10 years, and the total amount paid on these loans would be $52,490 (“No Assistance Received” column in Table 2).
The second column of Table 2 assumes the borrower’s employer is able to contribute $141 per month over five years to reduce the principal balance of the employee’s loans. In this example, the monthly payment would remain the same, but the loan would be repaid 28 months earlier, and the borrower would have been responsible for paying $40,105 in interest and principal, and $2,120 in taxes on the assistance received.
It is also assumed that the employee would have been able to invest the $437 per month at 4 percent (after tax) for the remaining 28 months of the originally scheduled loan term, which would have reduced the NPV to $28,055 from $47,539. If the employee had instead received the monthly employer assistance and decided to invest it over the 10-year loan term at 4 percent (the “Not Applied to Loans” column of Table 2), the NPV would have been $38,887.
Even though the borrower would have been able to start investing earlier (if given the option), using employer assistance to pay down the debt quicker provided an opportunity for the borrower to invest more each month after the loans were paid off. The borrower also benefited from the effects of compound growth much sooner, hence the accumulation of $12,953 rather than $11,414 at the end of the repayment term.
In scenarios where the loan balance is relatively manageable (as in, the borrower plans on repaying the loan over 10 years), the additional payments made by the employer are allocated to principal, and the interest rate on the loan exceeds the after-tax investment rate of return the borrower could earn on their investments. This type of benefit is financially acceptable for the borrower and should be considered an effective employee benefit.
Scenario 2: Moderate Income; High Loan Balance; Standard Repayment
The next scenario, as seen in Table 3, considered a borrower with the same $50,000 of annual income, but a larger loan balance in the amount of $100,000 with an average interest rate of 6 percent. Applying the same employer-provided student loan repayment assistance assumptions as in Scenario 1, the borrower shortens the repayment period by 11 months and would have an NPV of $100,782 (second column of Table 3) if they were to apply the assistance to their loans as opposed to $120,657 (first column of Table 3) if they were to decline the assistance.
In alignment with the results from Scenario 1, accepting employer-provided student loan repayment assistance is financially acceptable for the borrower in Scenario 2 and preferable to declining the assistance or investing it.
For sensitivity analysis purposes, additional cases were run assuming the borrower had an annual income of $75,000 and a loan balance of $150,000 with average interest rates of 5 percent and 6 percent for comparison purposes. While applying the employer’s assistance to the loans still saved the borrower from paying additional interest and would be financially preferred over the other options (over a 10-year period), the effectiveness of this assistance increased as the loan balance increased and decreased as the loan interest rate decreased. However, given the high debt-to-income ratio for this borrower and high required monthly payments, it was logical to look at this same scenario assuming the borrower were to participate in an income-driven repayment plan such as PAYE.
Scenario 3: Moderate Income; High Loan Balance; PAYE
Given the same assumptions as in Scenario 2 and assuming the borrower’s annual income increases at 3 percent each year, Table 4 illustrates that the starting monthly payment would decrease to $262 from $1,110, and the repayment term would extend from 10 years to 20 years. These assumptions were chosen because based on the debt-to-income ratio, the income growth rate, and the current formula for calculating discretionary income under the PAYE repayment plan, this borrower would have a loan balance remaining comprised of the original principal and unpaid accrued interest at the end of the repayment term. The total amount paid under each of the three circumstances would be $88,214 ($11,786 less than the original amount that was borrowed).
Assuming no employer-provided student loan repayment assistance was received (first column of Table 4), the borrower would have a remaining loan balance of $131,785. That balance would be forgiven and taxable as ordinary income at the end of the 20-year repayment term.
If a combined effective federal and state income tax rate of 35 percent was assumed, the tax on this forgiveness would be $46,125, and the total amount paid by the borrower would be $134,339, resulting in an NPV calculation of $101,882. When employer-provided student loan repayment assistance is factored in (second column of Table 4), the NPV increases to $101,923. This is primarily due to the present value effect on the payment of the tax liability associated with the employer-provided assistance occurring earlier in the repayment period.
In this scenario, the employer assistance reduced both the unpaid interest and the principal. Tax planning comes into play at the beginning of the repayment term when the borrower is receiving assistance, and when the borrower is receiving forgiveness and cancellation of debt at the end of the repayment period. Therefore, financial planners should be providing guidance to borrowers that help them save effectively for the lump sum tax bill they will likely face in 20 years.
If the borrower was able to negotiate for a raise, bonus, or additional compensation (third column of Table 4) to be paid directly to him or her, and assuming it can be invested to earn 4 percent over the same 20-year repayment period, the NPV would decrease to $89,104, indicating that this would be the preferred option for the borrower. The borrower would have still paid the same $88,214 over the 20-year period and would have incurred a higher tax liability upon forgiveness in the amount of $46,125. However, the borrower would have benefited from the compound growth on the monthly investment in this scenario, which would leave the borrower with $17,016 at the end of the repayment term.
Based on this finding, one strategy for loan borrowers to consider is to pay as little as possible on federal loans under income-driven repayment plans if they plan on receiving forgiveness in the future to reduce the effective interest rate on their loans and decrease the NPV of the loan (assuming they are able to efficiently invest the excess funds). Although the borrower will be responsible for paying a lump sum tax bill, the income-driven repayment plans can enable borrowers to save for other financial goals such as marriage, home ownership, and retirement.
The difference in NPV calculations may not appear to be substantial, and they can vary based on the assumptions used; however, it is important for financial planners to run projections to determine whether the borrower is likely to qualify for loan forgiveness in the future and whether he or she will be better off accepting the employer-provided student loan repayment assistance, declining to receive the assistance, or negotiating to receive the additional compensation directly, which can then be invested.
For sensitivity analysis purposes, a similar scenario was run to see if the effects would be the same when the annual income of the borrower increased to $75,000 with a 3 percent annual growth and the borrower had a larger loan balance of $150,000 with an average interest rate of 5 percent. The analysis indicated similar results with smaller variances in NPV calculations, which were not materially attributed to the increased loan balance once the borrower was already in a position to have the original balance forgiven at the end of the repayment period. Rather, the results were attributed to the decreased interest rate on the loan, which in turn, reduced the interest accrual and the value of the taxable forgiveness at the end of the repayment period.
Borrowers will typically benefit more by investing additional available funds rather than applying them to their loans when the projected after-tax rate of return exceeds the interest rate on the loans. However, requiring a higher after-tax rate of return is not always needed in cases where the borrower is enrolled in an income-driven repayment plan.
Scenario 4: Moderate Income; High Loan Balance; PAYE; PSLF
Scenario 4 (Table 5) considered a borrower with an annual income of $60,000 carrying a federal loan balance of $100,000 with an average interest rate of 6 percent who is on the PAYE repayment plan and is employed by a qualifying public service organization.
The analysis assumed the borrower’s annual income grew at 3 percent and that he or she remained employed in a qualifying public service organization while making the 120 qualifying payments. A key variable that changed for this scenario was the amount of the employer-provided student loan repayment assistance. Listed in Table 1 and omitted from the average employer assistance figure of $141, were the U.S. government agencies that provide up to $10,000 annually in student loan repayment assistance with a maximum of $60,000 to help employees pay down the balance of their federal student loans.10 This is close to six times more than the average amount corporate employers are currently offering, which seems like an amazing benefit. However, the analysis concluded just the opposite under certain conditions.
In the previous scenarios, the employer’s student loan repayment assistance helped reduce the principal and accrued interest totals that would later be forgiven and taxed as ordinary income. However, because loan forgiveness of debt under the public service loan forgiveness program is tax-free, the amount being forgiven is essentially irrelevant to the borrower.
The employer-provided student loan repayment assistance is included in the employee’s taxable income by most U.S. government agencies11, therefore a portion of the future tax-free loan forgiveness is converted to taxable loan forgiveness sooner in this scenario. When no employer-provided student loan repayment assistance is being received, the total amount paid on the $100,000 loan would be $48,215. However, when factoring in the assistance, the total amount paid increases to $54,215 and the borrower would be responsible for an additional tax liability in the amount of $15,000 on the employer assistance that would be provided over six years.
The analysis showed that if the employee were to not participate in the student loan repayment assistance program, he or she would not have incurred the tax liability on the assistance and the NPV would have decreased from $63,055 to $43,366. In this scenario, not receiving the employer-provided student loan repayment assistance would be preferable to receiving it. Borrowers may be better off foregoing participation in this type of employer-provided assistance program if they anticipate having the principal balance of their loans forgiven under PSLF and if this type of assistance continues to be included in taxable income.12
The scenarios presented here did not factor in the additional benefit of tax-deferred growth that could be received if the employer were able to contribute the assistance into the employee’s retirement account as an employer contribution, or if the employee were able to take these additional funds and contribute them to an IRA, Roth IRA, or HSA (if enrolled in a high deductible health plan) given the employee would receive a tax deduction for contributions made into the HSA and would benefit from tax-free growth if the distributions were used for qualifying medical expenses in the future. A few companies, including Abbott Laboratories and Prudential Retirement have crafted student loan repayment assistance programs in this fashion.13
The findings of this paper affirm that it may be more beneficial for employees who will qualify for loan forgiveness under an income-driven repayment plan to invest this additional compensation toward a long-term financial goal, such as retirement. This would especially be the case if the assistance would be treated as a pre-tax employer contribution that would allow the employee to benefit from tax-deferred compound growth.
With the IRS’s release of a private letter ruling (PLR 201833012)14 on August 17, 2018, Abbott Laboratories’ 401(k) plan structure was approved to allow the company to make a matching contribution equal to 5 percent of the employee’s compensation to the employee’s retirement account if the employee directs at least 2 percent of his or her qualifying compensation toward paying student loans. Even though private letter rulings cannot be claimed by other taxpayers as a precedent, this PLR does provide some insight on how the IRS would view this type of retirement plan structure. This is timely, as more companies consider this benefit as an alternative to providing the type of student loan repayment assistance that has been discussed previously throughout this paper.
Borrowers who can choose between these two types of student loan repayment assistance programs provided by their employer will need to work with a planner who can run the type of analysis discussed here to determine which option is best. Such an analysis would take into consideration the borrower’s goals and account for other variables noted in this paper, rather than only relying on comparing the interest rates on the loans with expected investment rates of return.
It can be difficult for planners to run these types of projections with sufficient accuracy, because they rely on several variables that can change drastically over time, such as annual income, marital status, tax filing status, family size, poverty guidelines, and projections of after-tax rates of return. However, planners are encouraged to run a comprehensive analysis for borrowers, especially if it enables them to strategically pay down their federal student loan balances efficiently and save more for other goals such as retirement.
Although debt management is an important part of financial planning, recommending that borrowers pay down their federal student debt as quickly as possible may not be the most optimal solution in every case, especially when considering the benefits associated with income-driven repayment plans and public service loan forgiveness.
See the consumer credit outstanding data from the Board of Governors of the Federal Reserve System at federalreserve.gov/releases/g19/HIST/cc_hist_memo_levels.html.
The income-contingent repayment plan (ICR) uses 100 percent of the poverty line in its discretionary income calculation.
Borrowers on the PAYE repayment plan can have only their annual income used in the calculation if they are using the single or married filing separately tax filing status.
See “99.5% of People Are Rejected for Student Loan Forgiveness Program,” in Forbes at forbes.com/sites/zackfriedman/2019/01/03/student-loan-forgiveness-data/#51b7f7c568d0.
See the Society of Human Resource Management research report, “2017 Employee Benefits: Remaining Competitive in a Challenging Talent Marketplace.” Available at shrm.org/hr-today/trends-and-forecasting/research-and-surveys/pages/2017-employee-benefits.aspx.
See the 2017 American Student Assistance “Young Workers and Student Debt” survey report. Available at asa.org. Survey results indicate that half of employees find student loan repayment assistance from the employer to be an important benefit.
See the 2017 Oliver Wyman report, “The Student Loan Repayment Benefit: Opportunities to Serve a Pressing Financial Need.” Available at aba.com/Products/Endorsed/Documents/Oliver%20Wyman%20Student%20Loan%20Benefit.pdf.
See the definition of educational assistance per IRC Section 127 at gpo.gov/fdsys/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapB-partIII-sec127.pdf.
Bills H.R. 795 and H.R. 4135 were introduced in the House of Representatives in late 2017 to allow student loan repayment assistance to be covered under IRC Section 127 and to extend the annual amount of educational assistance covered under IRC 127 to $11,500. Access the bills at congress.gov/bill/115th-congress/house-bill/795/text, and congress.gov/bill/115th-congress/house-bill/4135/text.
See the U.S. Office of Personnel Management’s website for information pertaining to student loan repayment assistance programs as defined in 5 U.S.C. 5379 at opm.gov/policy-data-oversight/pay-leave/student-loan-repayment.
See endnote No. 10.
See the U.S. Office of Personnel Management’s Q&A document on the tax implications associated with student loan repayment assistance programs at archive.opm.gov/oca/pay/studentloan/HTML/QandAsTax.asp.
Abbott Laboratories provides an additional employer contribution to an employee’s 401(k) plan in the amount of 2 percent of the employee’s salary, if they are currently making payments on their student loans and regardless of if they are making a voluntary employee contribution to the 401(k) plan. Prudential Retirement also has a similar type of assistance plan in place.
See Private Letter Ruling 201833012 at irs.gov/pub/irs-wd/201833012.pdf.
Abraham, Katharine, Emel Filiz-Ozbay, Erkut Y. Ozbay, and Lesley J. Turner. 2018a. “Framing Effects, Earnings Expectations, and the Design of Student Loan Repayment Schemes.” National Bureau of Economic Research working paper No. 24484. Available at nber.org/papers/w24484.
Abraham, Katharine, Emel Filiz-Ozbay, Erkut Y. Ozbay, and Lesley J. Turner. 2018b. “Behavioral Effects of Student Loan Repayment Plan Options on Borrowers’ Career Decisions: Theory and Experimental Evidence.” National Bureau of Economic Research working paper No. 24804. Available at nber.org/papers/w24804.
Asher, Lauren, Diane Cheng, and Jessica Thompson. 2014. “Should All Student Loan Payments Be Income-Driven? Trade-Offs and Challenges.” The Institute for College Access and Success white paper. Available at eric.ed.gov/?id=ED560047.
Canché, Manuel S. González. 2017. “Financial Benefits of Rapid Student Loan Repayment: An Analytic Framework Employing Two Decades of Data.” The Annals of the American Academy of Political and Social Science 671 (1): 154–182.
Conzelmann, Johnathan G., T. Austin Lacy, and Nichole D. Smith. 2018. “Another Day Another Dollar Metric? An Event History Analysis of Student Loan Repayment.” Education Finance and Policy Summer: 1–46.
Herbst, Daniel. 2018. “Liquidity and Insurance in Student Loan Contracts: Estimating the Effects of Income-Driven Repayment on Default and Consumption.” Unpublished working paper available at drive.google.com/file/d/1A-gq_LIqffY6r2gDTcUK9-Y3ZV8Go6SU/view.
Riskin, Ross A. 2019. “Evaluating the Effectiveness of Employer-Provided Student Loan Repayment Assistance Programs.” Journal of Financial Planning 32 (2): 34–43.