How to get Obamacare at an affordable rate

Update: As a result of the Tax Cuts and Jobs Act being signed into law, the tax code for 2018 has changed and the numbers cited below for standard deductions/personal exemptions will be different (the personal exemption of $4,150 is eliminated, but the standard deduction is doubled to ~$12,000). Your MAGI will increase or decrease slightly, but probably not too much. You can still use qualified retirement accounts (401k, Traditional IRA, etc…) and health savings accounts (HSAs) to reduce MAGI. This article will be updated once the IRS issues guidance on the new rules.

When I discuss Obamacare with people, the most common complaint I hear is that it’s too expensive. One middle-class family of three was paying $1,700 per month for a high-deductible insurance plan (which wasn’t actually on the exchange). Another claimed a “$30 per month plan was unaffordable” because her husband was out of work. Neither of these people had ever actually shopped for a plan on the exchange, because they just “wanted nothing to do with Obamacare”. Others report that their income is too high.

I was able to get the first family a plan for $236 per month. The second family would almost certainly qualify for free coverage through Medicaid, although they wanted nothing to do with it.

This article is addressed to people that “make too much money” to qualify for subsidies – you probably can – and to the people that say they can’t afford it because it’s too expensive.

Obamacare Subsidies and the Federal Poverty Line

The first thing you need to understand about Obamacare is how its subsidy structure works – everything is based off of the federal poverty line (FPL). The federal poverty line is based off of the number of people in your household (e.g. you, your spouse, and anyone you claim as dependents.) For example, if you file taxes as an individual, the federal poverty line for 2018, as it applies to you, is $12,060. If you are a family of three, your federal poverty line is $20,420.

Persons in Household100% FPL138% FPL250% FPL400% FPL
1$12,060$16,642$30,150$48,240
2$16,240$22,411$40,600$64,960
3$20,420$28,179$51,050$81,680
4$24,600$33,948$61,500$98,400
5$28,780$39,716$71,950$115,120
2018 Federal Poverty Lines in the Continental U.S. Add $4,180 to 100% FPL for each additional dependent. If you live in Hawaii or Alaska, see these charts instead.

 

Obamacare works by subsidizing health insurance for consumers with a modified adjusted gross income (MAGI) up to four times the federal poverty line (400% FPL). A family of three with a MAGI of $80,000 per year will receive a discount of ~$1,700 per month off their health insurance. In my area, this family could buy a health insurance plan for as little as $236 per month. I do not think that is expensive to cover three people. If you make more than this or you tell me that it’s a high-deductible plan, then keep reading, I’ll get to you…

Insurance plan for a family of three based on $80,000 MAGI

At the other end of the spectrum, a three person family with a modified adjusted gross income less than 138% of the federal poverty line – $28,179 per year – will pay nothing for their health insurance, assuming they live in one of the 33 states that chose to expand Medicaid. The person claiming “$30/Mo is too expensive” most likely qualifies for Medicaid, but because she refuses to go to the exchange for ideological reasons, she doesn’t have coverage. In states with expanded Medicaid coverage, there is no means testing – you can qualify based on income alone. See this page for more info on qualifying.

Finally, consumers with a modified adjusted gross income above 138% of the federal poverty line but below 250% – $51,050 for a family of three – will qualify for “extra savings”, which is an additional subsidy on silver plans to lower premiums and deductibles. As your modified adjusted gross income increases, the size of your subsidy decreases, meaning you pay more towards premiums and have higher deductibles. A family of three with a MAGI of $30,000 per year can get a silver plan for $20 per month with a $350 deductible and $1,200 out-of-pocket maximum. The same family on the same plan with a MAGI of $45,000 will pay $189 per month with a $4,500 deductible and $11,700 out-of-pocket maximum. They can also get a bronze plan for $4 per mo.

Insurance plan for a family of three based on $45,000 MAGI

As you can see, Obamacare is structured to make health insurance affordable by having the government pay a portion of it, based on your income. The more you earn, the less the government pays towards your insurance.

Understanding the components of Modified Adjusted Gross Income (MAGI)

It’s important to understand that there are different deductions you can take to lower your modified adjusted gross income. Assuming you do not itemize your deductions, right off the bat you get to subtract $6,500 (or $9,550 for families) and a personal exemption of $4,150, from your income. Then you get to deduct things like alimony, student loan interest, retirement contributions, tuition costs, and health savings account contributions. Common deductions are listed on lines 23-35 on IRS form 1040.

Assuming you are paid a salary of $30,000 in 2018, your adjusted gross income might look something like this:

Gross Income$30,000
Adjusted Gross Income$18,550
Standard Deduction($6,500)
Personal Exemption($4,150)
Student Loan Interest($800)

If you entered $30,000 on healthcare.gov for a single individual in my area, your premiums would be $185 per month, with a $2,250 deductible and a $5,850 out-of-pocket maximum.

Insurance plan for an individual based on $30,000 MAGI

If you entered $18,550, your plan would cost far less – $48 per month with a $750 deductible and $1,450 out-of-pocket maximum.

Insurance plan for an individual based on $18,550 MAGI

To someone that makes $30,000 per year BEFORE TAXES, $185 per month for a plan with high deductibles seems expensive. But the plan for $48 per month seems reasonable, at least in my opinion. It should seem extremely reasonable if you’ve ever owned an insurance plan prior to Obamacare becoming law.

The larger point I’m trying to make is that the more deductions you take, the lower your healthcare costs will be. If you are a family of three making $82,000, you should throw $400 into an IRA, because this will lower your income below 400% of FPL, qualifying you for subsidies, and saving you about $1,700 per month in insurance costs. If the $30k salary person above contributes another $1,908 towards a retirement account, they will be under 138% of the federal poverty line, which qualifies them for Medicaid. So their choice is to pay $48 per month in premiums, or invest $159 per month into an asset they’ll get to withdraw in retirement. Nearly anyone can open an IRA, including young people.

If you’re self-employed, you can leverage a lot of options to lower your income. For example, a person earning $100,000 can contribute ~$8,400 to an SEP IRA and $5,500 ($6,500 if you’re over 50) for a traditional IRA, lowering your income by $13,900. Certain plans with high deductibles qualify for health-savings accounts, in which you can shelter an additional $2,700 per family. These deductions would put a family of three making $116,000 below 400% of the federal poverty line, qualifying them for subsidies.

Gross Income$116,000
ADJUSTED GROSS INCOME$80,750
Standard Deduction (Family)($9,550)
Personal Exemption ($4,150 x 2)($8,300)
Student Loan Interest($800)
SEP IRA Contribution($8,400)
Traditional IRA Contribution($5,500)
HSA Contributions($2,700)

Furthermore, each person earning income can make these contributions. So if both you and your spouse work for employers offering 401k accounts, you can each contribute up to $18,500 ($37,000 total) and reduce the amount from your taxable income.

Is this complicated? Yes. Is it worth it? Absolutely. You get health insurance in case anything happens, and you’re putting away a substantial amount of money towards your retirement (you get to keep all those contributions). By not doing this, you pay the full unsubsidized price for your health insurance, which costs an extra $20,400/year, instead of saving $19,400/year. This is a net gain of nearly $40,000.

Setting up a SEP IRA (or one of the many other types of retirement accounts) is not necessarily straightforward, so you should get someone qualified to help you. Roth IRAs are after-tax money, so anything you put in there will not lower your adjusted gross income.

For a full list of what you can deduct, see the deductions page on healthcare.gov.

Final Thoughts

If you do it correctly, I do not think Obamacare is unaffordable. Is it expensive? Yes, but then again, so is our healthcare system. I had a routine surgery a year and a half ago. I walked in at 7AM and was out by noon. The bill was $21,500. My responsibility? $50. We don’t see a lot of the costs of our medical system because they are absorbed by insurance, but it is far more to deliver healthcare in the US than in other parts of the world (for various reasons that have nothing to do with Obamacare). Somebody is paying that tab, and the fact that it even costs $21,500 for a few hours in the operating room is insane.

While this tax jargon crap may seem complicated and unwieldly (and I agree that it is), it is worth it to get affordable coverage.

Common Questions:

What if I don’t know what my income is going to be?

You need to have some sort of estimate. When you sign up for health insurance, the government will pay an amount based on this estimate to your health insurer. If you have an adjusted gross income higher than this estimate at the end of the year, you will need to pay back the difference on your tax return. If you estimated your income too low, you will receive the difference back. The amount you are required to pay back is listed on the IRS website. You will use IRS form 8962 to reconcile the amount of subsidies you are entitled to at the end of the year.

If your income is more than 400% of the federal poverty line, you need to pay your entire premium back, so it’s important to stay below that number. You do not want to get hit with a tax bill for $20,000. Do whatever it takes (legally) to reduce your MAGI below 400% FPL.

If your income is less than 100% of the federal poverty line, you will also need to pay your entire premium back, so make sure you do not go below that amount (Medicaid recipients don’t have premiums, so this doesn’t apply to them). You can take money out of a retirement account (you will need to pay income taxes and penalties on it), but it’ll count towards income to get you above the threshold.

If you are self-employed and really aren’t sure what you’re going to make, I’d suggest putting in a lower amount and staying on top of your books, so you’ll know what you’ll owe when tax time comes. Or, you can estimate a higher income and get money back. It depends on the type of person you are, but either way it will be a good time to learn an accounting system like QuickBooks, or to hire a bookkeeper/accountant to keep you apprised on your financial standing (this is a business expense, which will also lower your adjusted gross income). It may also help you decide when it’s appropriate to make financial business decisions – for example, in order to keep yourself under the 400% FPL, you might decide it’s better to hire someone to do some of your tasks, rather than pay an extra $20k in insurance costs. Bookkeepers are usually around $30-60/hr, and accountants can cost between $75-150/hr. Accountants can usually train you to use QuickBooks (mine charged me something like $75, and set up my accounts for me).

What if I lose my job/income?

Obamacare subsidies are based on your annual income, while Medicaid is based on your monthly income. If you lose your job in March and your three-person family’s income drops to $2,300 per month, you and your family can apply for Medicaid and be covered until you get another job. If you were receiving coverage through your employer, you are covered retroactively for 60 days from the time you leave your job through COBRA. So if you quit, get hit by a car, and need to go to the emergency room, you can buy COBRA up to 60 days AFTER you leave your job, and it will apply retroactively. You will need to pay the full amount (the employee + employer portions, which can hundreds or thousands of dollars), as well as any deductibles, but that is better than a $60,000 emergency room bill.

The Medicaid advice only applies if you live in one of the 33 states that expanded Medicaid. If your state did not expand Medicaid, I’m not sure what your options are (I suggest you start by calling the number on healthcare.gov).

If you lose coverage from work, get married, have a kid, or some other life qualifying event, you’ll be eligible for a special enrollment period to purchase coverage outside of open enrollment. You must apply for coverage within 60 days of the qualifying event.

What if I earn more money than I estimated?

You will need to pay the difference back. If you earn more than 400% FPL or less than 100% FPL by the end of the year, you will to pay the entire amount back, so don’t get caught in that situation.

You have until April 15th the following year to make IRA and SEP IRA contributions, so if you find that you are $5,000 over the 400% FPL limit, contribute $5,000 before April 15th and you should be OK. Other deductions are required to be paid in the year they are deducted, so this should be incentive to get your financial situation under control well before December 31, giving you time to make any necessary adjustments.

Explain Health Savings Accounts (HSAs) to me

Health Savings Accounts (HSAs) allow you to put money into a tax-free savings account. For example, if your adjusted gross income (AGI) is $30,000 and you put $1,000 into an HSA, your AGI is now $29,000. There are certain stipulations for HSAs – you must have a plan with a deductible over a certain amount and an out-of-pocket maximum below a certain amount, but in these circumstances, they work well. I believe (but am not entirely sure) you are also allowed to put money into an HSA and immediately withdraw it to pay medical expenses. So if you have a plan with a $4,000 deductible and need to go to the emergency room, you can put money into your HSA and then pay it from there. The contribution to your HSA will lower your AGI, which may result in you getting more money back at the end of the year, because your AGI will be lower than what you first reported, qualifying you for more subsidies.

You keep any money you contribute to an HSA, it rolls over from year-to-year, and you can invest it to grow (it works like a retirement account, for health-related expenses). This is a good solution for high-deductible plans, although some of the out-of-pocket maximums are too high to qualify. You should evaluate whether it is better for you and your family to select an HSA-eligible plan with lower premiums and higher deductibles, or higher premiums and lower deductibles, based on your estimated healthcare needs.

There are other types of HSA-like plans available, but you’ll need to do your own research because I’m not too familiar with them.

What else can I do to lower my MAGI?

If you work for a small employer that does not provide health insurance, or provides insurance through the exchange, ask them to look into setting up 401k plans for their employees. Even if it offers no employer-matching component, the 2018 contribution limit is $18,500, so you could earn quite a bit above 400% FPL, and put money away to bring it down below that amount. If both you and your spouse work, you can each contribute up to $18,500 of earnings per person to an 401k ($24,000 if you’re over 50). Using only the standard deduction, personal exemption, and 401k, a family of two can earn up to $120,170 and still qualify for subsidies. If you have additional deductions, you can earn even more.

If you earn below 250% FPL, there is a huge advantage to putting as much into retirement accounts as possible. Ideally, you want to offset whatever you are spending on premiums by redirecting them to your retirement account, because anything that goes into your retirement account is yours to keep.

Unlike an IRA, 401k contributions need to come directly from your paycheck, and need to be funded in year they are deducted (you only have until Dec 31 to make these contributions, not April 15). Make sure you know where you stand financially well before the year ends, so you have time to make adjustments if necessary.

There are other retirement accounts you may want to investigate here (though not all of these are tax-deductible).

If you have a really high income, you should meet with a tax specialist and figure out how to get your income below 400% FPL. For example, if you own rental property, one option might be to take out a home equity loan on your rental properties, which will increase your mortgage interest deduction expense. Then you can invest that money into something that is not taxed as regular income – for example, a growth ETF will only be taxed when you sell it and realize any gains. Doing so may have unintended consequences (high-risk investments may not be appropriate for people needing to cash out in less than 10 years, for example). Getting a good financial planner that can answer these questions for you will be key to figuring this out.

I don’t understand “premiums”, “coinsurance”, “deductible”, “out-of-pocket maximum”, and other insurance jargon…

Check out the glossary on healthcare.gov. The link is in the footer if you ever need to find it later. This does a good job explaining different terms with examples. I also suggest calling the phone number listed on healthcare.gov and speaking with someone if you have questions.

Where can I get more information?

This site is a good resource that explains a lot about the Obamacare subsidies.

How does Modified Adjusted Gross Income (MAGI) differ from Adjusted Gross Income (AGI)?

MAGI is AGI, plus a few deductions added back in. For many people, MAGI is the same as AGI.

To learn more about MAGI, see this page on healthcare.gov.

What else should I know?

  • On December 22, 2017, the Republicans passed the Tax Cuts and Jobs Act, which affects all of the numbers cited in this article for 2018 tax returns. The TCJA eliminates the personal exemption, but doubles the standard deduction, so most people’s adjusted gross incomes will change slightly. I will update this article once the IRS issues new guidelines regarding the new law.
  • To shop for plans and pricing without creating an account, check out this link.
  • You need to actually purchase a plan on the exchange to qualify for subsidies. If you buy an insurance plan outside of the exchange, you do not get any subsidies.
  • Your household income includes income from your spouse as well as your claimed dependents. If you have kids that earn more than the standard deduction, make sure you factor this into your financial plan. If you’re really close to the 400% FPL, you might be able to gift them up to $5,500 and have them put it into an IRA, wiping out their net income for the year. (Gifts up to $14k are not taxable to the recipient.)
  • I am not an accountant. This information is provided as-is and without any warranties. While I feel this information is well-researched and correct (it is the research I have accumulated to get health insurance for myself), I take no responsibility for any omissions or errors, or problems that may arise from using this information. If you have any questions, I highly recommend you seek financial advice from a qualified tax accountant.

Other Questions?

Leave a comment in the comments section, and I’ll help you if I know the answer.

 

Once a week is not 4x per month [Budgets]

A common mistake I see in people’s budgets are bi-weekly costs multiplied by two, and weekly costs multiplied by four, to arrive at a “monthly” amount. If you are developing a budget for the entire year, this will leave you short a few payments. A better method is to annualize the cost, and then spread it out over 12 months to arrive at a “monthly amount”. This is an easy adjustment to make, and one which will not leave you shortchanged at the end of the year.*

For example, let’s say that you spend $100 per week on cleaning services for your home or office. The “wrong” method is to take this number and multiply it by 4 to get $400 per month, then multiply it by 12 to get $4,800 per year. This leaves you with a budget of 48 weeks – four fewer than the 52 weeks in a year. A better method is to multiply your weekly amount by the number of weeks in a year (52), and then divide by the number of months (12).

 

“Wrong” method:
X $100 x 4 weeks x 12 months = $4,800 per year or $400 per month

Better/Annualized method:
$100 x 52 weeks / 12 months = $5,200 per year or $433 per month ($400/yr difference)

 

Because there are 52 weeks in a year, you will always have 4 months with 5 short weeks, resulting in 5 pay periods for that month. For 3/4 of the months under the annualized method, you will under-spend your budget by $33. For the remaining 1/4 of the months, you will overspend it by $100, balancing everything out.

 

For services billed bi-weekly, multiply the cost by 26 and divide by 12. For example:

“Wrong” method:
X $100 x 2 weeks x 12 months = $2,400 per year or $200 per month

Better/Annualized method:
$100 x 26 weeks / 12 months = $2,600 per year or $217 per month ($200/yr difference)

 

For services billed every four weeks, multiply the cost by 13 and divide by 12. For example:

“Wrong” method:
X $100 x 1 weeks x 12 months = $1,200 per year or $100 per month

Better/Annualized method:
$100 x 13 weeks / 12 months = $1,300 per year or $108 per month ($100/yr difference)

 

If you have trouble remembering how many periods there are in a year, just remember there are 52 weeks in a year. Divide that by two to get the number of bi-weekly periods (26), or divide 52 by four to get the number of four-week periods (13).

  # Periods Per Year Conversion-to-Monthly Formula
Weekly 52 [Weekly Amount] x 52 / 12
Bi-Weekly 26 [Bi-weekly Amount] x 26 / 12
Every Four Weeks 13 [Four-Week Amount] x 13 / 12

 

I used an example of janitorial services at a fixed rate of $100/week, but the same thing could happen anytime you bill in one unit and pay in another – for example, you bill your customers a service contract at $1,000/mo, but you budget your technicians by the week. If you budget them at $250/week, you’re going to be short at the end of the year. If you’ve set up a budget and you feel like you’re perpetually missing your targets, make sure you aren’t making this common mistake.

A few notes:

  • Although paychecks follow the same rule (you get paid on a weekly or bi-weekly basis, not monthly), I like to intentionally use the “wrong” method for calculating my monthly income because it means I will have EXTRA money at the end of the year. People more frequently overspend than under-spend budgets, so this is an easy way to give yourself a little extra wiggle room.
  • When you divide 365 days per year by 7 days per week, you get ~52.14285, or 52 weeks and one day in a non-leap year. For most purposes, the 52 rule for weekly, 26 for bi-weekly, or 13 for every four weeks work fine, but if you’re budgeting for something where the exact number of days matter, like payroll, make sure you get your numbers down to the day. I’ve seen even large institutions make this mistake, so double-check your numbers!

I saved my friend $65,000 on $20,000 of student loans.

I took a look at my friend’s finances (we’ll call her Samantha,) and after playing with the numbers for a couple of hours, I was able to turn $23,196 worth of student loan debt into what will be a $42,000 asset; a net gain of more than $65,000. This process uses the Income-Based Repayment (IBR) and Public Service Loan Forgiveness (PSLF) programs, and lasts 10 years. Here’s how you do it.

DISCLAIMER: This article uses complex financial strategies that involve principle risk. Each person's financial situation is different, and the methods described below may not be the best fit for your unique situation. Consult a certified financial expert before implementing any of the strategies on this website. This information is provided "as is" and "use at your own risk."

The chart below lists each of Samantha’s student loans along with information provided to us by the lender, such as current balance, monthly payment, and interest rate. Beside that, I have calculated pertinent information, such as the number of payments remaining until the loan is paid off, the number of years remaining until the loan is paid off, the amount of interest she will accumulate, and the total amount she will pay per loan (current balance + interest) from today.

Current Loans

LoanCurrent BalancePaymentAPRNumber of Payments RemainingYears LeftTotal InterestTotal Paid
TOTAL$19,369$315.43746.1$3,827$23,197
GSMR A1, A2, A4$3,901$30.904.18%16613.8$1,245$5,146
GSMR B5$4,731$96.086.80%584.8$827$5,558
GSMR C3$1,435$18.582.65%857.0$140$1,574
Great Lakes FFEL$4,719$104.546.00%514.3$639$5,358
Great Lakes FFEL$4,583$65.335.60%857.1$977$5,560

From the chart above, we can see that the sum of Samantha’s loan balances is currently $19,369, requiring 74 payments of $315.43 over the next 6.1 years to pay off. During this time, her loans will accumulate an additional $3,827 in interest, bringing the total cost of the loans to ~$23,197.

Two simple steps anyone could normally take in this situation would be to 1) refinance the high-interest loans and 2) pay more than the minimum amount required. As shown in the table below, by reducing the interest rate on four out of her five loans and doubling her monthly payment, Samantha will save $2,773 in interest, assuming she qualifies for a 3.38% rate ($23,197 – $20,423 = $2,773). Even refinancing alone while keeping the same monthly payments would save $1,536 in interest (not shown).

Refinanced Loans

LoanCurrent BalancePaymentAPRNumber of Payments RemainingYears LeftTotal InterestTotal Paid
TOTAL$19,369$630.86322.7$1,054$20,423
GSMR A1, A2, A4$3,901$61.803.38%695.8$399$4,300
GSMR B5$4,731$192.163.38%252.1$178$4,909
GSMR C3$1,435$37.162.65%403.4$66$1,501
Great Lakes FFEL$4,719$209.083.38%231.9$163$4,882
Great Lakes FFEL$4,583$130.663.38%373.1$248$4,831

Samantha works for the office of campus recreation at a local university, and has an adjusted gross income (AGI) of around $20,000. Although her position is not related to any sort of educational benefit, her employer is a 501(c)3 non-profit organization, which qualifies her for the Public Service Loan Forgiveness (PSLF) Program. PSLF allows any person working for  government or qualified non-profits to have their federal student loans forgiven after 10 years if they are on Income-Based Repayment (IBR) plans. “Forgiven” means the federal government will pay off any remaining loan balances for you at the end of 10 years.

If we examine any 10-year period for the stock market, we see, on average, an approximate 10% return per year.  This means that if we were to invest $100 each month for 10 years, after 10 years we will have invested $12,000, but would expect to have earned another $7,125 through returns (a total of $19,125). Furthermore, if these earnings come in the form of capital gains – which means the stock price appreciates but the companies do not pay dividends (think startups like Tesla as opposed to Utility Companies) – we do not count this as “income” until we sell the assets. You don’t actually earn any money from growth stocks until you sell them (i.e. when the gains are “realized”).

So how do we use this knowledge to our advantage? We leverage the Public Service Loan Forgiveness Program (PSLF) with Income-Based Repayments (IBR) to repay all our debt.

Income-Based Repayment (IBR) plans cap the amount of your monthly payments on your federal student loans at 10-15% of your discretionary income. Discretionary income for this purpose is defined as any amount of your adjusted gross income (AGI) over 150% of the Federal Poverty Level (FPL). The Federal Poverty Level is based on how many persons you have living in your household (persons = dependents such as kids, your spouse, your elderly grandmother, etc. It does not include roommates.) If you’re a single individual with no kids living in the continental United States, your 2017 Federal Poverty Level (FPL) is $12,060; 150% of that is $18,090. The Federal Poverty Level (FPL) increases at the rate of inflation, usually around 2% per year. The table below lists 2017 federal poverty levels by household size for people living in the continental US (Hawaii and Alaska have slightly higher FPLs):

Federal Poverty Levels

Persons in Household2017 Federal Poverty Level150% FPL
1$12,060$18,090
2$16,240$24,360
3$20,420$30,630
4$24,600$36,900
5$28,780$43,170
6$32,960$49,440
7$37,140$55,710
8$41,320$61,980
Federal Poverty Levels for the 48 continental states + D.C.

A single individual with an adjusted gross income (AGI) of $18,090 or less in 2017 has no discretionary income, and therefore will have student loan payments of $0 under Income-Based Repayment (IBR). As you earn more, your monthly student loan payment amount will rise by 10-15% of the amount over your FPL. The table below shows student loan payments at various levels of income. A single individual with an AGI of $40,000 a year will have payments between $182.58 and $279.88 per month; someone with an AGI of $50,000 will have payments between $265.92 and $398.88 per month. Whether you pay 10% of your discretionary income or 15% depends on the type of federal loan you have and when you opened it, but we are not concerned about this for our plan.

Monthly Loan Payments

Adjusted Gross Income (AGI)Annual Discretionary Income (ADI)Monthly Discretionary Income (MDI)Monthly Loan Payments at 10% of Discretionary IncomeMonthly Loan Payments at 15% of Discretionary Income
AGI - 150%FPLADI / 12MDI * 10%MDI * 15%
$15,000($3,090)($257.50)$0$0
$17,500($590)($49.17)$0$0
$18,090$0$0$0$0
$20,000$1,910$159.17$15.92$23.88
$22,500$4,410$367.50$36.75$55.13
$25,000$6,910$575.83$57.58$86.38
$30,000$11,910$992.50$99.25$148.88
$35,000$16,910$1,409.17$140.92$211.38
$40,000$21,910$1,825.83$185.58$273.88
$45,000$26,910$2,242.50$224.25$336.38
$50,000$31,910$2,659.17$265.95$398.88
Your monthly loan payment is calculated by multiplying your monthly discretionary income by 10 or 15%.

While the monthly payments on your student loans may be reduced or eliminated, it is important to understand that the interest on them still accumulates. Despite making monthly payments of $23.88, the balances on Samantha’s loans will increase to $29,981.77 after 10 years (see table below). That’s because the monthly interest accumulation on her loans is more than her payment of $23.88. Without substantially higher monthly payments, these loans will never be paid off. So how does Income-Based Repayment (IBR) work in our favor?

Loan Payments on Income Based Repayment (IBR)

LoanBalancePaymentAPR# Payments RemainingYears LeftBal After 10 Yr
TOTAL$19,369$23.8812010$29,982
GSMR A1, A2, A4$3,901$4.784.184%12010$5,213
GSMR B5$4,731$4.786.8%12010$8,503
GSMR C3$1,435$4.782.65%12010$1,213
Great Lakes FFEL$4,719$4.776%12010$7,804
Great Lakes FFEL$4,583$4.775.6%12010$7,248

Earlier I stated that by putting $100 per month into an investment fund with a 10% expected rate of return, you can reasonably expect to have ~$19,125 after 10 years. We also know over 10 years, our loan balances will balloon to $29,982 under IBR. So what we want to do is figure out how much we need to put away in order to end up with $29,982 after a 10-year period.

The following chart shows total returns for an investment over a 10-year period at different interest rates. For example, if you put $275 per month into an investment that yields a 10% return, you will have $52,594 in 10 years; $200 per month at 8% will yield $34,768; and so forth.

Returns on an Investment Over 10 Years

Monthly Contribution5%6%7%8%9%10%
$291$43,940$46,046$48,267$50,608$53,076$55,676
$275$41,507$43,497$45,594$47,806$50,137$52,594
$250$37,734$39,542$41,449$43,460$45,579$47,812
$225$33,960$35,588$37,304$39,114$41,021$43,031
$200$30,187$31,634$33,159$34,768$36,463$38,250
$190$28,678$30,052$31,502$33,029$34,640$36,337
$175$26,414$27,680$29,015$30,422$31,905$33,469
$150$22,640$23,725$24,870$26,076$27,347$28,687

As anyone that sells financial products will tell you, historical performance does not guarantee future returns. Just because the average gain for a particular mutual fund over the past 10 years was 10%, doesn’t mean that will happen for the following 10 years (in fact, you could lose all of your investment, including principle). As someone that likes to plan for the underwhelming results, I assumed that our investment grew at 6% per year. This means that in order to earn at least $29,982 after 10 years, we need to invest $190 per month for 10 years into a growth fund that appreciates 6% per year (according to our table above). If our fund performs on target, we’ll have $30,052 after 10 years. If it does better, great, but I wouldn’t plan for this to happen; always plan to be underwhelmed.

Let’s recap:

  • Samantha has $20,000 worth of federal student loans, which she currently pays $315/mo towards.
  • Samantha earns $20,000 per year working for a non-profit. Under an IBR plan, her loan payments will be ~$24/mo.
  • Samantha’s loans will be forgiven under the IBR/PSLF Program after 10 years.
  • By paying $24/mo towards her student loans, Samantha’s loan balances will balloon to ~$29,982 after 10 years
  • Putting $190/mo into an investment that appreciates 6% per year will result in a balance of $30,052 after a 10-year period.

If it isn’t clear what we’re doing, we’re taking the money that we would normal pay towards student loans and redirecting them into an investment vehicle that will appreciate at 6% per year. At the end of 10-years, our student loans will be paid off by the federal government, but the investment will still be ours to keep. The practical effect of this is as follows:

Samantha’s monthly payments will be reduced from $315/mo to $214/mo, putting an additional $101 per month of cash into her pocket. The $214 per month is divided between a $190 investment contribution and a $24 student loan payment. The value of the extra cash at the end of 10 years is $12,120 ($100/mo * 120 months).

At the end of 10 years, the Public Service Loan Forgiveness (PSLF) Program will pay off the $29,982 balance on her student loans. Samantha should also have ~$30,052 sitting in an investment account, which she can now cash out. When this is added to the $12,120 in cash she’s saved from lower monthly payments and the original loan that has been forgiven ($23,197), she will have experienced a net gain of more than $65,000!

There are several assumptions made in order for this to work:

  • The investment vehicle needs to be something that is taxed as capital gains. Earning dividends results in ordinary taxable income that cannot be deferred. Ordinary income means a higher adjusted gross income, which means higher student loan payments. Growth-focused investments with low dividend yields (or Roth IRAs) will not have this problem.
  • Samantha needs to maintain an adjusted gross income at or near 150% of the federal poverty level ($18,090 in 2017) for 10 years.
  • Samantha needs to work for a qualified employer and and make 120 loan payments while on the Income-Based Repayment plan. Neither of these have to be continuous, although both conditions must be true at the time of the payment, or else it doesn’t count towards Public Service Loan Forgiveness (PSLF).

What happens if Samantha makes more money (resulting in a higher AGI)?

Even when your salary grows, there are still a number of ways to reduce your adjusted gross income (AGI). The simplest and most common method is through contributions to qualified retirement accounts. Contributions to a 401k, 403b, or 457 supplemental plan are “above the line” tax deductions, meaning they lower your AGI. Samantha could potentially earn up to $54,090, contribute $18,000/year to her 403b and $18,000/year to her 457 (assuming her employer offers these), and still pay nothing on her student loan payments. ($54k Income – $18k 403b Contribution – $18k 457 Contribution = $18,090 AGI, which is 150% FPL, which means no student loan payments).

Other above-the-line tax deductions include:

Even if you make $54k/yr, you’ll still be living like a poor person until the 10 years is up. If you only have $20k in student loans, and you start your career making $54k, I would advise you to just pay off the debt like a normal person (maybe refinance and increase your monthly payment amount). However, if you’re 8 years into this plan and your salary jumps to $54k, reduce your AGI by maximizing your retirement contributions and just stick it out for the remaining two years. You can also try negotiating non-taxable, non-salary compensation increases with your employer, such as additional vacation time.

What happens if Samantha wants to change jobs?

If Samantha changes jobs from one qualified employer to another (e.g. one non-profit to another non-profit), she’ll need to complete and submit a new Employment Certification form, but other than that, not much will change. Her loan payments will continue to qualify, and she’ll keep credit for all of her previous payments.

If Samantha decides to leave government/non-profit and work in the private sector, she’ll no longer qualify for PSLF payments. We’ve attempted to mitigate this scenario by putting money in an investment vehicle that grows at a rate equal to her student loans. If for example, after 5 years, Samantha quits her job to go elsewhere, her student loan balances will have increased to $23,457. If she’s kept up with her investment contributions and those investments have hit our target growth of 6%, the value of her portfolio should be around $12,850 (calculations for these numbers are not shown). She can sell this to pay off half her loans, and then make payments as she normally would to pay off her loans. Note that she will need to pay capital gains taxes (usually 10-15%) on the amount her investments have appreciated.

One risk associated with this is assuming a 6% return on your investment. While investments historically average a 10% return per year over long periods of time, you can still have years with negative growth. For example, take a look at this graph:

A Graph of the Annual Total Return on the Dow 1930-2011
Chart source: investorsfriend.com

Although the average return may be 10% per year, this may be the result of being down 30% in year 1, and up 30% in years 2 and 3, and so forth. Regular contributions spread out over a long period of time greatly reduce this risk, but the fact remains that if you suddenly need to pull out your money, you risk doing so in a “down year”. This article does a good job at explaining this concept. You can also read about Dollar Cost Averaging, which is one way we have mitigated this problem.

Would you recommend Income-Based Repayment (IBR) and loan forgiveness for employees of for-profit companies?

It depends on your unique circumstances. I would say probably not, but it might work if your loans are astronomical. The problem is that forgiveness programs for for-profit employees take 20-25 years to take effect. This means that you will need to earn an adjusted gross income at 150% of the federal poverty level for 20-25 years, something I think most people are not willing to do (someone graduating at 21 will be 46 by the time their loans are forgiven). On the other hand, I think it’s reasonable to get a job as a teacher or join the Peace Corps or do something similar for 10 years in your twenties, and then use your investment to put a down-payment on a house, start a business, or other invest into other income-generating assets when you’re 30.

What do you recommend for people that have a lot of non-federal student loans?

The Public Service Loan Forgiveness (PSLF) program only applies to specific types of federal student loans. The first thing you should do with all private loans is to refinance them to lower interest rates. This will generally save you a lot of money. Some of the lenders that do this include Sofi, DRB Financial, and Common Bond. Be careful though – refinancing federal student loans will make those loans ineligible for income-based repayment.

The next thing you can do is to increase your monthly payments towards high interest non-federal student loans. By increasing the amount of your payment each month, you are in effect borrowing money for a shorter amount of time, which means you pay less in interest. Cumulatively, this can save you thousands or even tens of thousands of dollars in interest charges.

Also be aware that private loans payments have no effect on your federal student loan payments. The sum of your federal student loan payments will be 10-15% of your discretionary income, regardless of what your non-federal student loan payments are.

If you have massive amounts of student debt that you think will not be repayable, you may want to consult a bankruptcy attorney. Bankruptcy can discharge your debt, but the process will ruin your credit for the next 7-10 years. It’s not something I’m too familiar with but I know that it is an option, and for some people that have hundreds of thousands of dollars in debt and a job that only pays $30,000/yr, it might be a good idea to consult an attorney.

What fund should I invest in?

I’m not the right person to ask here, because I’m not a certified financial advisor, but I would imagine something like the Vanguard Small-Cap Growth ETF (VBK) would be appropriate. The key is to invest in a well-diversified fund targeted at equity appreciation and not dividends (you want growth stocks, not value). Any income earned through dividend payments will be considered ordinary income, and added to your adjusted gross income, which will cause your monthly student loan payments to increase. The Vanguard Growth ETF (VUG) is a little less risky, but you’d earn more as dividend income.

Another option to consider is putting your first $5,500/yr into a ROTH IRA, which would allow you to invest in any kind of fund and grow it tax-free. You wouldn’t be able to cash out any gains until retirement (unless you pay a penalty,) but you could cash out any principle put in there penalty- and tax-free. You would also have the added benefit of more funds with greater diversification and/or less risk. Speak with a certified financial advisor and ask them what the best option is for your situation.

What other risks are there?

There are a few risks that I haven’t really touched upon:

  • The federal government could end or significantly alter the Public Service Loan Forgiveness (PSLF) program in some way that makes this plan no longer work. The Trump administration has talked about modifying PSLF, but hasn’t given any details on what he plans to do. I am not an attorney, but I would think that if you sign up for income-based repayment (IBR) before they change it, they would need to honor the terms of their original agreement. But if you have concerns about this, you should ask an attorney.
  • The economy could crash and burn. The worst case scenario would be that your investments are essentially worth nothing, you lose your job because the economy is in the gutter, and because you are no longer working for a non-profit, your PSLF discharge date is pushed back. If this happens, I would probably hold onto your investments, wait for the economy to recover, and then sell them when you’re ready. This is a “what-if” you’ll want plan for with your financial advisor, along with plans for if you change jobs, suddenly inherit lots of money, etc…
  • Any other risks I may have missed. I’m not a lawyer, certified financial planner, or certified public accountant. This plan was developed from knowledge I’ve gained from studying the tax code while running my business, and through learning about investment products over the years. Someone that is certified in this arena of expertise and does it every day is going to have a greater understanding of the specific financial products that will work best for you. Many employers even offer financial planning services for free – talk to your human resources department and see if they have someone you can meet with. Just make sure whomever you speak with has a fiduciary duty to act in your best interest.

What else should I know?

You need to apply for Public Service Loan Forgiveness (PSLF) at the end of your term (it doesn’t happen automatically). See this website for more information.

You should complete and submit the Employment Certification form as soon as you switch to IBR. Too many borrowers wait to submit this important form until they have been in repayment for several years, at which point they learn that they have not been making qualifying payments. In order to ensure you’re on track to receive forgiveness, you should continue to submit this form both annually and every time you switch employers.

You should also read the Federal Student Aid website, which has lots of answers to common questions, such as what happens if you switch employers, if you only work 9 months out of the year, or what qualifies as “full time” employment.

There are specific loan forgiveness programs for teachers, some of which forgive after 5 years. If you’re a teacher, you may want to look into these instead of the generic 10-year Public Service Loan Forgiveness (PSLF) program.

You’ll be living like a (somewhat) broke person for 10 years. You’ll want to create a budget for an income of ~$20,000 (or whatever you decide), which includes the modified student loan payment + investment contribution, rent, car payment, cell phone, insurance, food, entertainment, etc… can you afford to do that? You may need to get creative or find ways to reduce your expenses. If you do something like PeaceCorps, most of your food and housing will be taken care of for you, and your time with them will count towards your Public Service Loan Forgiveness (PSLF) contributions.

If you get married, your AGI income will be the combined income of you and your spouse. If your spouse earns a lot more money, it will affect your payment terms under IBR. Be aware of the financial ramifications if you plan on getting married in the next 10 years.

You may need to wait until the tax year following the discharge of your loans through PSLF to cash out your investment. In the year you sell your investment, your AGI will be much higher, and I don’t know if the loan provider would come back and say that you weren’t paying enough towards your student loans that year. While I think this scenario is unlikely, I’d still recommend looking into it and reading the exact terms of the forgiveness.

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