A lot of press and TV time has been spent on the Occupy Movement . A lot of it focused on what could be a lost generation of Americans coming out of college buried in student loan debt. For this reason I have chosen to dedicate this post to something that’s bothered me for a long time. I’m a tax attorney specializing in resolving back tax debts. As I work through my client’s options for resolving their tax debts I’m constantly amazed that they have more options and a better chance of putting their tax debt behind them than a person with student loan debt.
One can judge the logic of these students taking out massive student loans to fund their educations, but their actions were certainly no worse than an individual who did not file or pay their taxes, right? So, why would the government’s treatment of these two debts be so diverse? The treatment and options for resolving these two types of debts are so different that if I were to advise a potential client in dire financial straits which debt to pay first, I would be sorely tempted to recommend that they pay their student loan before their taxes. Here are six factors to consider when deciding whether student loans are worse than income tax debts.
Factor #1: What is the Interest Rate Charged
There is a variance in the interest charged for student loans dependent mostly on when the loan was originated or consolidated. In recent years, student loan interest rates have fallen to as low as 4.5%, but what about the borrowers who graduated college 5, 10, 15 and 20+ years ago? They are paying interest rates of up to 8.25% per annum. Here’s a link to student loan historical interest rate data http://www.finaid.org/loans/historicalrates.phtml .
The interest rate for underpaid Federal Income taxes changes with the Federal Reserve rate. Currently the interest rate charged for income tax debt is 4%, but it has been as high as 9% in the last decade, but that was only in the very early 2000s. Here’s a link to underpaid income tax interest rates http://www.taxalmanac.org/index.php/Federal_Underpayment_Interest_Rates.
But student loan interest is tax deductible right? Most people believe that student loan interest paid is always tax deductible while in reality for a lot of Taxpayers it is not. First of all, the maximum deduction for student loan interest paid is $2,500 per year regardless of the actual amount of student loan interest paid. Second, your student loan interest deduction begins to phase out when income exceeds $60,000 for single filers and $120,000 for joint filers. The student loan interest deduction is completely phased out when income reaches $75,000 for single filers and $150,000 for joint filers. Also, if you file married filing separate you are not allowed to take the student loan deduction at all. So if you make enough money to actually pay your student loan you’re probably not going to get a tax break for it.
Interest paid on a back tax balance is not deductible in any situation. So in this regard student loan debt is better than tax debt. At least it might be partially tax deductible.
Factor #2: Income Tax Debts are dischargeable in bankruptcy and Student Loans are not
Hopefully it never comes to it, but more and more Americans faced with overwhelming debt are filing for bankruptcy protection. For better or worse, student loans are almost never dischargeable in bankruptcy. The only time that it will even be considered is in cases of extreme hardship. The Courts have not ruled definitively on what extreme hardship is but it almost always involves extreme financial woes coupled with a physical or mental challenge.
Contrary to popular belief income taxes can be discharged in a bankruptcy. There are restrictions, but in a lot of cases they can be wiped completely away. The general guidelines for discharging personal income taxes in a bankruptcy are that they must have been due more than three years prior to the filing of the bankruptcy and if filed late the balance due must have been assessed more than eight months prior to the bankruptcy filing. In addition the taxes will not be discharged if there were any issues of fraud or tax evasion related to the income tax debt in question.
Sure you may have to wait a few years, but in the end the fact that you can discharge income taxes in bankruptcy does make them a more attractive debt than a student loan.
Factor #3: There is no time limit for collection of a student loan whereas the IRS has only 10 Years
A student loan will never expire. A student loan collector can chase you for this debt until the day you die and if they’ve reduced it to judgment can even collect it from your estate. The government has announced new income sensitive repayment programs where in you pay them 10-15% of your disposable income over 20 to 25 years after which the debt will expire. There are limitations. Most of the programs are only available to recent graduates and as your income goes up, your payments will go up, so it may end up that by taking this option you end up paying the loan in full and with more interest than if you went with a traditional repayment plan. The upside is you won’t be in default and you should have enough money to afford to meet your base nutritional needs, even if you are forced to live in your parent’s basement.
All IRS debts have a 10 year collection statute expiration date meaning that if the IRS does not collect the balance from you in 10 years it disappears for good. This is regardless if you’ve paid them a penny. If you can hold out and survive for 10 years you’re done and can start a new financial life. There are circumstances where the IRS has filed a tax lien and then reduce that lien to a judgment which would give them an additional 10 years, but I have never seen them do it. Not once in ten years of practice.
This factor clearly favors income tax debt over student loan debt. Ten years is a long time, but it’s nothing compared to a life time.
Factor #4: Is the debt Secured or Unsecured and will there be Public Notice of the Debt?
A student loan debt is an unsecured debt meaning that they do not record a lien or file a UCC Financing Statement against you. This means, that if you can qualify for a loan (despite your student loan balance) you can buy and sell real estate without the government being paid from the proceeds of sale. So technically you’re not as tied down as you would be with a secured debt, but based on the fact that they report the amount owed to the credit reporting bureaus student loan debt will still be considered by any lender. It will drive down your personal equity and reduce your net available income when considering whether you can afford that house payment. Your credit score will also be significantly lower due to the student loan balance which also makes it more difficult to get a loan. For many people this will result in them being unable to purchase a home or buy a vehicle at a favorable interest rate, if at all.
Depending on how much is owed and what you’re doing to repay it a Federal Tax Lien may or not be filed against you when you owe income taxes. The IRS has recently loosened their standards for filing tax liens. If you owe less than $25,000 and can afford a 60 month payment agreement they will not file a tax lien against you and will even release a previously filed tax lien. Furthermore, unless a tax lien is filed, the tax debt will never be reported to the credit reporting bureaus thus it won’t impair your credit score.
If you owe more than $25,000 in tax debt and you’re not able to pay it off over 60 months then a Federal Tax Lien will be filed which will tie up any assets you have now or hope to have in the next ten years. It will drive down your credit score and may even affect your ability to get a job. So in this instance, the size of the tax debt is a deciding factor in deciding which type of debt is worse.
Factor #5: What are the settlement options?
The reality is that there is no real settlement option for student loans. If you’re willing to work in the public sector or at a non-profit for the next ten years there are programs in which you can have your student loans forgiven. There is also a new income sensitive repayment plan for new graduates in which you pay 10-15% of your disposable income for 20-25 years at which point the debt will be forgiven. The problem with this is that as your income increases you just pay more to your student loan debt. You may end up paying it in full with a massive amount of interest. The other options is you don’t pay it in full and it goes away, but either way you’ve spent the last 20 to 25 years being effectively poor. Any extra money you’ve made has gone to increased student loan payments.
They also have forbearance where in you do not have to make payments, but they’re going to capitalize the interest accrued during that year and interest will just keep accruing thereafter. After you begin making payments again all of those payments are going to go to that capitalized interest before you even begin to touch the principal. If you think about it from their perspective, why would they ever agree to settle a debt that is guaranteed by the U.S. government, non dischargable in bankruptcy and never expires. Student loans are what banker’s fantasies are made out of.
The IRS has one main settlement option, beyond bankruptcy for income tax debts, the Offer in Compromise. This much maligned and much abused program is still an incredibly effective tool for eliminating a large IRS balance due. Basically, if you can prove to them that you have minimal equity in assets and minimal disposable income (expenses calculated under IRS standards not actual expenses) then there is a good chance you can settle your income tax debt with the IRS and you don’t even have to go through the bankruptcy. In fact, if you move forward with your offer in compromise tax settlement proposal fast enough there may not even be a tax lien filed, meaning no negative mark on your credit report. Even if you don’t qualify for an Offer in Compromise tax settlement, the IRS has all the same, forbearance (currently not collectable) and income sensitive repayment plans (partial pay installment agreement) except that instead of waiting 25 years for the debt to expire, it expires in 10 years.
Reason #6: Who is more aggressive collecting their debt, the IRS or a Student Loan lender?
IRS collections has a tough reputation that is generally well deserved. If you ignore them or refuse to comply with their requests they will levy your bank accounts and your wages, as well as take your income tax refunds and file a tax lien against you. If you stay in contact with them and comply with their requests for documentation they will consider your overall financial situation and try to come up with a workable solution to your issue. They may even recommend to you to file an Offer in Compromise to settle the tax debt. The major difficulty in working with them is just a lack of knowledge and expertise in the programs that are available. A knowledgeable tax attorney specializing in IRS collections can guide you in this regard.
Enforcement of a delinquent student loan can be undertaken by the original bank, Sallie Mae or by a private collection agency so it’s hard to say definitively how aggressive a collector they are, but in the end they have all of the same collection tools as the IRS. They can intercept tax refunds, levy wages, levy bank accounts and sue to collect the debt in civil court. They can also reduce the debt to a judgment so they can legally attach real estate holdings.
Sounds unbelievable, but for a person in dire financial straits and when viewed from a debt management and resolution perspective, IRS income tax debt is better than student loan debt. The reason is that when you look at these two very common debts it becomes clear that the options for resolving income tax debts are much better. Would I as a tax attorney ever advise a client in this situation to pay their student loan before their income tax debt? Yes, in the right circumstance I would.