The good news for most recipients of a gift or inheritance is that the extra money typically won’t cause an increase in their student loan payments. For those who fall under an exception, there is a workaround to keep payments manageable.

What does an Inheritance have to do with Student Loans?

To see how this issue can play out, we turn to a recent email. One of our readers, Daphne, is concerned about her student loan payments going up due to an inheritance she is going to receive.

Daphne writes:

Dear Student Loan Sherpa,

Thank you so much for this amazingly helpful resource. I have spent hours scouring articles and forum questions, and although I have gleaned and confirmed valuable information, the topic of my question has not been directly addressed. I am on year 3 of a 25 year IBR plan. (15% discretionary income and 25 years to forgiveness). Currently, my payments are at zero as I have not been working due to illness.

If I were to either inherit or be gifted a large lump sum (larger than the total of the loans, which has grown to about 75k because of capitalized interest), how would that affect my payment plan for that year and ongoing? I have spoken to 5 different people, both at the Dept of Ed itself and my servicer Nelnet, who all said the same thing but could not direct me to where I could find the answer in writing. They said that since inheritance or gift is not considered income, it would not affect my repayment. I understand that if the lump sum is invested, the accrued income would then be considered income.

Thank you!

The Basics – IDR Calculations

One of the major benefits of income-driven repayment plans is that they make student loan payments more affordable. The Department of Education designed these plans so that borrowers could afford their monthly payments regardless of how much they owe. Daphne worries, quite reasonably, that a large inheritance or financial gift will cause an increase in her monthly payments.

Fortunately for Daphne, the government’s formula for calculating affordable payments is quite straightforward. It looks at your state of residence, how many people are in your family, and what you reported on your most recent tax return. Using this information, your loan servicer calculates your discretionary income, and sets your monthly payment based on that. To see this calculation in action, be sure to check out the Department of Education’s Loan Simulator.

Adjusted Gross Income – The Important Number

The key figure from your tax return that affects the student loan payments under an income-driven plan is your adjusted gross income (AGI). In general, as this number goes up, so do your monthly payments. Likewise, if your AGI goes down, your student loan bill will, too.

Therefore, Daphne’s question really boils down to a tax question. Does an inheritance or financial gift have an impact on your adjusted gross income? If the IRS considers the inheritance or gift to be income, her student loan payments will increase. If not, there will be no impact on her student loan payments.

Inheritance Taxes and Student Loans

To determine if an inheritance or financial gift will increase your student loan payments, it’s best to first consult an accountant or tax preparer. An accountant preparing your tax return will know whether or not the inheritance will increase your AGI.

Generally speaking, inheritances are not taxed on the beneficiary (the person receiving the inheritance). It is usually the person providing the inheritance who is expected to pay the taxes on it. This concept is handled similarly when looking at gift taxes and student loan help from family.

It is worth noting that, even if an inheritance is not taxed at the federal level, there might be state taxes to consider. Fortunately, even if there are state taxes, it won’t affect your student loan payments.

The Dreaded Exception and How to Get Around It

Unfortunately, the basic rules do not apply to all inheritances.

The most common example would be beneficiaries receiving a traditional IRA or a 401(k) inheritance. These retirement accounts contain untaxed funds. The recipient of the account will then be responsible for paying tax on the income.

An IRA or 401(k) beneficiary may see a temporary one-time jump in their AGI. This can result in higher student loan payments. Here again, a good accountant or tax preparer can provide exact numbers and options for dealing with the tax spike.

Fortunately, a recent tax return isn’t the only way to verify your income. Borrowers with a tax return that doesn’t accurately reflect their earnings can submit alternative documentation of income. Typically, this alternative documentation takes the form of recent paystubs. However, the process isn’t always simple, so a phone call to your servicer can help avoid any potential issues. These tactics can be used to “skip” a high-income year from student loan calculations.

Bottom Line

The formula for calculating a borrower’s ability to make student loan payments is fairly straightforward. It mostly depends on the AGI from your most recent tax return. In Daphne’s case, this is a major benefit because it means an inheritance probably won’t increase her monthly payments.

In most cases, the recipient of a gift or inheritance gets the money free and clear. However, the gift giver might need to think about possible tax consequences.

The post Will Getting an Inheritance or Large Gift Increase My Student Loan Payments? appeared first on The Student Loan Sherpa.