Student Loan Planning in Response to COVID-19 and Recent Legislation

Journal of Financial Planning: June 2021

Dan Johnson, CFP^®, EA, is an assistant professor for the College for Financial Planning and a part-time instructor for Boston University. He primarily focuses on taxes and retirement planning for individuals and small businesses.

If you speak with any financial, tax, or legal professional, the consensus is usually the same—there has been an overwhelming amount of legislation passed in recent years. In 2017 there was the Tax Cuts and Jobs Act (TCJA), arguably the largest tax reform within the past two decades. Two years later, Congress passed the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), bringing substantial changes to the employee benefit and retirement space.

Then in 2020, the world came to a standstill due to the COVID-19 pandemic. To avoid a crippling and prolonged recession, the U.S. Congress passed three stimulus packages. The first was the Coronavirus Aid, Relief, and Economic Security Act (CARES Act),¹ and later came the Consolidated Appropriations Act.² Finally, and most recently, there is the American Rescue Plan Act of 2021—a $1.9 trillion economic stimulus bill that was signed into law by President Joe Biden on March 11, 2021.³

Altogether, each of the five bills impacts taxpayers in slightly different ways, but they share a high degree of correlation. This includes tax bracket and marginal rate adjustments, revised credits, stimulus checks, and employee benefit and retirement options. Yet despite the numerous legislative changes, there is one area that has gone relatively untouched: student loans.

Cost of Education

It is no secret higher education in the United States costs a small fortune, and as of 2021, there are roughly 43.2 million student borrowers and $1.71 trillion of outstanding student loan debt.⁴

During the 2018-2019 academic year, the average cost of attending a public four-year university was $24,900 per year. That number climbed to $33,200 and $51,900 per year for private for-profit and non-profit universities, respectively. As for graduate school, which is arguably becoming a necessity in today’s job market, students do not fare much better. During the same 2018-2019 school year, the average cost of attending a public or private university was approximately $12,000 and $26,000, respectively.⁵

Perhaps more alarming is that these numbers only reflect in-state tuition, do not include all applicable fees, and equate to an inflation increase of 8 percent per year. Nevertheless, upon graduation, students owe an average of $37,000, pay $393 per month at 6 percent interest, and take 20 years to fully repay their loans.⁶ By the time they finish repaying their loans, roughly $26,000 of interest has accrued, or 67.1 percent of the total loan cost.⁷

Overall, the cost of higher education can be crippling to students and ultimately inhibit them from moving on to other important milestones, like starting a family or saving for retirement.

Current and Potential Help for Loan Holders

Numerous reasons play a role in the rising cost of education, but federal loan holders may soon have a reason to celebrate, or at least enjoy temporary relief.

One reason is that the CARES Act temporarily postponed federal loan repayments until September 30, 2020, and later extended deferment through at least September 30, 2021. The CARES Act also suspended accruing interest on loans and now allows up to $5,250 of student loan debt to be paid by employers, tax-free, on behalf of loan holders.⁸

Meanwhile, Section 9675 of the American Rescue Plan Act does not tax any student loans that are forgiven between 2021 and 2025, including federal, state, institutional, and private loans.⁹ Note that the CARES Act and American Rescue Plan Act are both starkly different from the general rule of any discharged debt becoming taxable income to the debtholder.

However, there has been no official decision on forgiving student loans or when this might occur. President Biden has made it clear that broad student loan forgiveness is a priority of his administration and has already made plans to revamp an Obama administration program called “The Borrower Defense Program.” This program would forgive an estimated $1 billion in student loans but is notoriously known for having strict requirements that few loan holders qualify for.¹⁰

Perhaps more popular is President Biden’s endorsement of forgiving up to $10,000 in federal student loan debt per borrower. Some politicians, however, feel that is not enough and have pushed for up to $50,000 in forgiveness. Senate Majority Leader Chuck Schumer and Massachusetts Senator Elizabeth Warren have led groups of Democrats in this camp.¹¹

Regardless, with a temporary pause on federal loan repayments and the possibility of forgiveness looming in the future, financial advisers and their clients are left with a handful of options. Though by no means comprehensive, below are several strategies worth considering.

Continue paying off student loans. With loan repayments temporarily paused and no interest accruing, any continued payments will directly reduce the underlying principal balance. Given that federal loan interest typically averages between three to four percent, each payment leads to direct interest savings and a guaranteed rate of return.

For many, this appears to be the ideal choice because it can potentially knock years off loan repayments while saving hundreds and thousands in interest. However, paying off loans that could potentially be forgiven in the future, even if only partially, may prove risky. Thus, other strategies might be better.

Allocate payments toward other loans. Student loans are not the only loans weighing down students and post-graduates. Other common examples include car payments, mortgages, electronics, credit cards, and personal loans. The size and interest of each loan will vary, but the newfound cash flow from student loan forbearance can now potentially be allocated to other loans. Two common approaches include the “debt snowball” and “debt avalanche” methods.

The former involves making minimum payments on all debts and applying any excess cash flow to the smallest debt first, regardless of the interest rate. The idea here is that loan holders will receive a psychological boost upon paying off their first loan and be more motivated toward accomplishing their financial goals.

Conversely, the debt avalanche method entails applying extra cash flow to the highest interest-rated debt, regardless of the loan balance. In this case, loan-holders might not receive a psychological boost at first, but they would be saving more in long-term interest repayments.

Invest the loan payments. The debt repayment methods inherently assume there is a need or strong desire to repay loans at a faster rate. But what if those loans have favorable repayment schedules and interest rates? And what if the loan-holder has little-to-no long-term savings? In that case, clients may be better served by investing the student loan repayments and potentially earning a higher rate of return in the stock market.

Many options exist, including employer plans and qualified or nonqualified retirement accounts. Employer plans and qualified accounts are generally favorable thanks to their ability to lower taxable income and defer taxation into the future. However, given that many students or post-graduates are in the earlier stages of their careers, their earnings tend to be lower. As such, they may benefit from Roth 401(k) or IRA contributions instead. There is also a case to be made for nonqualified accounts—such as brokerage accounts—due to their liquidity, unlimited savings potential, and avoidance of penalties.

Regardless of which investment vehicle is chosen, simple math (i.e., loan interest versus reasonable market returns) may ultimately be the deciding factor. If invested, loan holders will be well on their way to saving for retirement and enjoying the miracles of compound interest.

Build an emergency fund. Admittedly, it is difficult to recommend a client invest for their future or accelerate other loan payments if they do not yet have an adequate foundation to build upon. Therefore, if a client lacks adequate liquidity and needs to safeguard against any unforeseen circumstances— such as a global pandemic—in this case, they may be better served by allocating those federal loan payments toward an emergency fund.

Every client will have different liquidity needs, but a general rule of thumb is three to six months’ worth of living expenses, plus extra for any anticipated irregular expenses. The cash can be held in certificates of deposits (CDs), high-yield savings accounts, money market funds, or even bond ladders, but overall it should be liquid and readily available. Once fully funded, excess funds can either be invested for long-term growth or applied to other debts.

Alternatively, clients can always stockpile student loan repayments in a savings account and earmark them as a temporary emergency fund. Once federal loan repayments start in the fall of 2021, loan holders can either apply backdated payments toward their student loans or use them for another purpose previously discussed. Either way, there is no rush to repay federal loans under current conditions.

Use for discretionary spending purposes. In the rare case a client has no other immediate needs for the newfound cash flow, advisers may consider encouraging them to simply spend the money. Perhaps the client wants to donate the funds or even take a vacation, especially as the airline industry revamps itself post-pandemic. Or maybe the client simply wants greater discretionary income to spend with friends and family they may have not seen recently due to COVID-19.

Whatever the reason, part of prudent financial planning is ensuring clients are secured for the future yet can still enjoy the immediate pleasures of life. After all, money is infinite while time is limited, and you cannot take the former with you should you pass away early. Thus, advisers should review the amount of monthly cash flow now available due to loan forbearance and work with the client to prioritize financial versus life goals.

Other Considerations

Although the discharge of student loans does not trigger income taxation until at least 2026, it is still unclear if President Biden’s proposals apply only to federal loans, or whether other loans will qualify too. It is also unclear if the type of college attended and/or the loan holder’s income will matter when determining eligibility.

In the meantime, it should be noted that the deferment of loan repayments generally applies only to federal loans. Thus, private loan holders will likely need to continue making their scheduled repayments. However, it never hurts to check with the loan company to see if better options exist.

Conclusion

Undoubtedly, COVID-19 has changed the lives of everyone around the world, including student loan holders. And while the issues surrounding higher education costs will not be solved any time soon, new legislation and talks in Washington, D.C. provide somewhat of a silver lining. Accordingly, and if not already done so, advisers may want to revisit the topic of student loans.

Yet even if a client does not hold student loans, maybe they have a close loved one who does and needs help now. As such, advisers may want to provide value-add by helping out those loved ones, even if they receive nothing in return monetarily.

That gesture alone may spark client referrals (that do generate revenue) because clients notice the adviser is going above and beyond the call of duty. And maybe, just maybe, that broke college kid eating ramen noodles might one day become the adviser’s most profitable client through inheritances and personal savings. Therefore, sometimes it pays (literally) to pay it forward.

In the end, student loans are not always the most exciting or profitable part of an adviser’s business, but if there was ever a time to revisit the conversation, it’s now.   

Endnotes

1. See the Coronavirus Aid, Relief, and Economic Security Act, 2020, at congress.gov/bill/116th-congress/senate-bill/3548.
2. See the Consolidated Appropriations Act, 2021, at congress.gov/bill/116th-congress/house-bill/133.
3. See the American Rescue Plan Act of 2021, at congress.gov/bill/117th-congress/house-bill/1319.
4. See “Student Loan Debt Statistics” from EducationData.org at educationdata.org/student-loan-debt-statistics/.
5. See “Digest of Education Statistics,” from the National Center for Education Statistics, U.S. Department of Education. Available at nces.ed.gov/programs/digest/2020menu_tables.asp.
6. Ibid.
7. See Endnote No. 4.
8. See both Endnote No. 2 and Endnote No. 3.
9. See Endnote No. 1
10. See “After Biden Cancels $1 Billion In Student Loans, 3 Potential Next Steps For Student Loan Forgiveness,” by Adam S. Minsky in Forbes at forbes.com/sites/adamminsky/2021/03/22/after-biden-cancels-1-billion-in-student-loans-3-potential-next-steps-for-student-loan-forgiveness/.
11. See “Biden Comes Out Against $50,000 In Student Loan Forgiveness—But Supports This Amount, Instead,” by Adam S. Minsky in Forbes at forbes.com/sites/adamminsky/2021/02/16/biden-comes-out-against-50000-in-student-loan-forgiveness/?sh=522853787590.