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If You Are Married With Student Loans, You Might Save Money By Filing Your Tax Returns Separately

Of course, this is easier said than done. In reality, the calculation and choosing how to file can get complicated.

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In an alternate universe where people are not burdened with nearly nondischargeable student loans, people file their tax returns with the goal of legally minimizing their taxes. But if a taxpayer is repaying their federal student loans through an income-based repayment program, they may be willing to pay more taxes in exchange for a larger savings on their student loan payments. This has created some anomalies in tax planning and tax return preparation. For example, most married couples file their tax returns jointly because it usually results in a lower tax bill. But if one or both spouses are on an income-based repayment plan, they may be better off filing separately.

If you are on the Income-Based Repayment (IBR) plan, the Pay As You Earn (PAYE) plan, or the older Income Contingent Repayment (ICR) plan for your federal student loans, then the monthly payment amount is determined based on your adjusted gross income (AGI) reported on your tax return. If you are filing as married filing jointly, then the monthly payment amount is determined by the combined income of you and your spouse.

Under the new Revised Pay As You Earn (REPAYE) plan, then the income of both spouses are considered regardless of whether the tax return is filed jointly or separately.

If one or both spouses are on an IBR, ICR, or PAYE plan, I would advise having their tax preparer compare what their tax bill will be when filing jointly and filing separately. I would also have them compare what their monthly IBR payments will be using their joint and separate AGI using an IBR payment estimator.

In general, it is more cost efficient for a married couple to file their tax returns separately if the reduction in student loan payments is greater than the tax increase. For example, suppose a married couple pays $3,600 more in taxes by filing separately instead of jointly. But if a spouse’s IBR payment is reduced by $4,800 annually, they will save $1,200 by filing separately.

Of course, this is easier said than done. In reality, the calculation and choosing how to file can get complicated. I’ll give an example with the numbers changed and rounded up to make calculations simpler.

One of my clients is a self-employed professional whose business income last year was $200,000. He has been on the PAYE repayment plan for three years and his current student loan balance is $330,000. He is married and his wife earned W-2 income of about $120,000 last year. His wife has no student loans. The couple has no children and they own a house with a mortgage.

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I prepared their tax returns both filing separately and jointly to see how changing their filing status would affect their tax and student loan bills.

If they file their tax return jointly, their combined AGI would be $320,000. With itemized deductions, their federal income tax is $52,700.

If they file separately, the husband’s AGI would be $200,000 and his income tax would be $42,700. His wife’s AGI would be $120,000 and her income tax would be about $18,800. So their combined tax would be $61,500. So by filing separately, they are paying an extra $8,800 in federal taxes.

They already paid in $35,000 through payroll withholdings and estimated tax payments. This leaves them with a balance of $17,700 if filing jointly or $26,500 if filing separately. Unfortunately, they do not have that kind of money at the moment. So regardless of how they file, they will have to pay the balance (plus penalties and interest) through an installment agreement.

According to the IBR calculator, based on the joint AGI of $320,000, the husband’s student loan will be $2,400 under the PAYE program. At this rate, he will have a remaining balance of approximately $80,000 after 17 years at which point the balance will be forgiven. But if the husband uses his own AGI of $200,000 by filing separately, he will pay about $1,500 per month under the PAYE plan. Also, assuming there is no change in future income, he will continue to pay this amount for the 17 years he has left under the plan. His projected loan forgiveness is approximately $350,000, which will be cancellation of debt income for tax purposes.

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If they file jointly, the couple will pay the following every month:

$2,400 – Student loan payment
$1,500 – Back tax payment for 12 months on the $17,700 balance
$3,900 – Total

Also, since they have a tax balance of $17,000, they should withhold an extra $1,500 per month so they won’t have a tax bill next year. So ideally they should be paying $5,400 per month for the next 12 months.

If they file separately, this will what their payments will look like:

$1,500 – Student loan payment
$2,300 – Back tax payment for 12 months on the $26,500 balance.
$3,800 – Total

Since they have a tax balance of $26,500 by filing separately, they should withhold an extra $2,300 per month to avoid a tax bill next year. So their optimal total will be $6,100 for the next 12 months.

Based on the above, my client is slightly better off by filing separately from his wife. He pays an extra $8,800 in federal taxes but will save $10,800 in student loan payments which results in a $2,000 net benefit. Also, in the long run, his remaining loan balance of $200,000 will be forgiven, although some planning should be done to minimize cancellation of debt income.

Another advantage to filing separately is separating the tax liabilities. Since my client is self-employed, he has an increased risk of being audited. In case an audit results in a tax bill, only he will be responsible for the bill and not his spouse.

On the other hand, the increased tax bill due to filing separately can create a financial hardship so the couple may have no other choice but to file jointly. The debtor can then ask his loan servicer for a lower monthly payment.

So if you are married and either one or both of you are on an income-based repayment plan, I highly recommend comparing how much tax and student loans you will pay filing separately and filing jointly. You may be financially better off filing separately.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at sachimalbe@excite.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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