387,000 Americans Now Face a Student Loan Forgiveness Tax

student loan forgiveness tax

Imagine coming home one day, opening your mailbox, and seeing an official-looking envelope from the U.S. Department of Education. Inside, you find a letter stating that your entire federal student loan debt has been forgiven.

While this may seem impossible, it really did happen for 387,000 Americans eligible for a total and permanent disability discharge this year. Federal student loan borrowers who can’t work because of a disability can have their loans forgiven.

While $7.7 billion in student loans will be discharged, or an average of $19,896 per person, that’s not the end of the story for these borrowers.

In fact, they may owe thousands of dollars to the Internal Revenue Service thanks to a student loan forgiveness tax attached to their forgiven debt.

Who qualifies for a TPD student loan discharge?

Paying for student loans can be a struggle for many individuals. But what about student loan borrowers who have a severe disability? For them, it can be nearly impossible.

If you are physically incapable of working for at least five years, the government offers a student loan discharge under the Total and Permanent Disability (TPD) discharge program.

A TPD discharge is only for federal student loans. These include Federal Direct Loans, Perkins Loans, and Federal Family Education Loans (FFEL). It does not impact what you may owe through private student loans.

If you’re a disabled veteran, you must provide a letter from the Veterans Administration stating that you are permanently disabled and unable to work due to a service-connected disability. Then you will qualify for a TPD discharge.

Or, perhaps you are receiving Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI) benefits. You can submit a Social Security Administration (SSA) notice of award for SSDI or SSI benefits stating that your next scheduled disability review will be within five to seven years from the date of your most recent SSA disability determination.

Additionally, anyone with a letter from their doctor certifying that they are totally and permanently disabled is eligible to apply for a student loan discharge under the TPD program.

How did President Obama get involved?

However, so many Americans didn’t know about this program that President Barack Obama decided to take action. He instructed the Department of Education to proactively discharge student loans for eligible Americans who had not applied.

The Department of Education matched records with the Social Security Administration database. They then searched for anyone with federal student loans and a Social Security disability status of “Medical Improvement Not Expected.”

Their initial query yielded approximately 387,000 results. Of those 387,000, about 179,000 are currently in default of their federal student loans.

If you default on federal student loans, you’re at risk of social security benefit garnishment, or tax refund garnishment to pay for the loans. Since many of those impacted rely on social security benefits to cover basic necessities like groceries and rent, a garnishment could push them well below the poverty line.

What happens when student loan debt is forgiven?

Within each letter sent to 387,000 permanently disabled Americans with student debt, there was a caveat: a student loan forgiveness tax.

Any student loans that are forgiven are treated like taxable income for that borrower. Unlike a student loan interest tax credit, which lowers your taxes, a student loan forgiveness tax requires paying taxes to the federal government.

Because the student loan amount forgiven is treated as regular income for tax purposes, you pay the same taxes as if you had earned that money at work. It may even bump you into the next income tax bracket.

What’s the tax cost of student loan forgiveness?

Let’s assume that the average person in this program is permanently disabled. And, they only have income from Social Security Disability Insurance.

The average monthly benefit of disability insurance in July 2016 was $1,028.17. That means the average person receiving SSDI at that time has a taxable income of $12,338.04 per year. Such a low income would make it extremely difficult for these individuals to pay back their student loans.

Additionally, if a person with that low of income paid an average of $1,395 in federal income taxes (not including state taxes), their income would be brought down further: $10,943 per year.

Now let’s assume that person has the average student loan balance being forgiven in the program: $19,896. That increases their taxable income to $32,234. Even though they really only brought in $12,338.

With this higher taxable income, their federal income taxes increase to about $4,373. Now they have to pay $4,373 in taxes on $12,338 worth of income. This leaves them with $7,965 to live on for the year. Hardly a livable income.

But remember, $19,896 is the average student loan balance. That means some may have much lower balances while others may have much higher balances.

Is student loan forgiveness tax relief on the horizon?

All hope is not lost for these disabled student loan borrowers faced with the big student loan forgiveness tax.

A bipartisan group of U.S. Senators introduced a bill in April 2016 titled “Stop Taxing Death and Disability Act.” It would eliminate a student loan forgiveness tax for Americans with permanent disabilities.

Although the bill is a long way from becoming law, it could provide relief for those unable to afford to pay a student loan forgiveness tax.

Whatever happens next, taxes on student loan forgiveness are a serious matter. Student loans are usually only forgiven for those in the worst financial situation. However, student loan forgiveness taxes can turn that monetary blessing into a tax curse.

Until the laws are changed, tax on student loan forgiveness lives on. So be sure to read up on all the pros and cons of receiving student loan forgiveness before accepting it.

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