RAP student loan plans may increase your payments. Tax planning can help

With a little strategy, federal student loan borrowers can lower their monthly bills under the U.S. Department of Education’s new repayment plan starting July 1.

In a Repayment Assistance Plan (RAP), a borrower pays a higher percentage of their income as their income increases. “That means if you find ways to reduce your pre-tax income even a little bit, you can reduce your monthly student loan payments,” says Landon Warmund, a certified financial planner and certified student loan specialist with Reliant Financial Services in Kansas City, Missouri.

“There are certainly some unique opportunities here,” said Warmund, a member of CNBC’s Financial Advisor Council.

Finding ways to reduce your monthly loan bill under the RAP may be especially important for the millions of borrowers forced to leave the Biden-era Savings for a Valuable Education (SAVE) plan. A federal appeals court earlier this year ended SAVE, the most affordable repayment plan ever.

Student loan borrowers will have about 90 days after July 1 to exit SAVE, and will often have to make higher payments under other plans.

“Borrowers can avoid these spikes in payments by considering what pre-tax benefits are available at their workplace to reduce their taxable income, which allows them to maintain their core income figures,” Warmund said.

Here’s how borrowers can reduce their payments under RAP.

With RAP, monthly payments typically range from 1% to 10% of revenue. The more you earn, the more payments you will need to make. The minimum monthly payment is $10 for all borrowers.

Current income-driven repayment plans (IDRs) offer $0 monthly payments to certain very low-income individuals.

Additionally, RAP, unlike other IDR plans, does not protect a portion of the borrower’s income as necessary expenses in calculating charges. Instead, payments are determined based on adjusted gross income. AGI is your gross income before taxes minus certain deductions.

For students enrolled in RAP, “even a $1 difference in AGI can have an impact of hundreds of dollars on the total student loan payment for a year,” Warmund said.

For example, the RAP formula means that a student loan borrower with an AGI of $59,999 per year could pay about $50 per month, or $600 per year, less than a borrower with an AGI of $60,000.

Carolina Rodriguez, director of the Education Debt Consumer Assistance Program in New York, a nonprofit that helps borrowers, said there are several ways that borrowers can reduce their AGI and therefore lower their monthly RAP bill.

Rodriguez said one option is to allocate a portion of your paycheck to your workplace’s 401(k) retirement plan, traditional IRA, or increase contributions to those accounts. Keep in mind: Money put into a Roth IRA or Roth 401(k) won’t help here, since these contributions must be pre-tax or deductible to lower your AGI.

If a student loan borrower contributes an additional $1,001 a year to a pre-tax retirement account, reducing their AGI from $71,000 to $69,999, their monthly RAP payments will drop from $414 to $350, Walmund said.

Rodriguez said pre-tax contributions to a health savings account (HSA) or flexible spending account (FSA) are additional options to lower your taxable wages. Companies can offer several types of FSAs, including eligible medical expenses, dependent care, and commuting expenses.

On the other hand, if you’re self-employed, claiming legitimate business expenses and deductions on Schedule C can result in the same result, Rodriguez said.

“This may include normal and necessary business expenses, retirement benefits, and health insurance deductions,” she said.

Other “above-the-line” deductions, such as student loan interest reductions, can also lower AGI.

Under the RAP plan, federal student loan borrowers can also have their monthly bills reduced by $50 for each dependent who claims, Rodriguez said. According to IRS guidelines, dependents often include minor children, but may also include siblings and other relatives in certain cases.

These savings are automatic and must be tied to your tax return.

“It’s based on the number of dependents the borrower claims on their federal tax return,” she said.

Even if you can reduce your monthly payments under a RAP, you may end up paying more over the life of your loan than you would with other plans, Rodriguez said. That’s because with RAP, student loan forgiveness only occurs after 30 years, compared to the typical 20- or 25-year timelines for other IDR plans.

As a result, some borrowers may want to compare their monthly charges and total payments under RAP to other repayment plans. However, RAP will be the only IDR plan available to student loan borrowers who take out loans after July 1.

Borrowers with existing federal student loans can maintain access to their current IDR plans, including income-based repayment plans (IBR). IBR borrowers are eligible for debt forgiveness after 20 or 25 years, depending on the age of the loan.

Current borrowers also have access to income-contingent repayment plans (ICR) and PAY (Pay As You Earn plans) until mid-2028, although neither program provides debt forgiveness at this time. The only reason you might want to sign up for one plan or the other is because it offers the lowest monthly payments, Rodriguez said.

If so, you can keep your ICR or PAYE until your plan expires on July 1, 2028. If you then switch to IBR or RAP, you will be entitled to a credit to forgive your previous payment.

“If RAP is your worst option, wait until it becomes available,” Rodriguez said. “But please be mindful of the implications of this plan.”