Surprise! Here’s When You’ll Owe Taxes on Student Loan Forgiveness

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If your student loan balance is hefty, you may have considered student loan forgiveness.

But you might not know about the student loan forgiveness tax bomb — the taxable portion of your forgiven student debt that you may be required to pay back to the IRS.

This can create hidden costs that are added to your tax bill. Here’s what you should know about taxes on student loan forgiveness.

Student loan forgiveness taxes and what you could pay

For many borrowers, income-driven repayment plans such as Pay as You Earn, coupled with student loan forgiveness, can be financial saviors. These repayment plans cap your student loan payments each month at 10% to 20% of your income.

After 20 to 25 years of steady repayment, your remaining balance is forgiven.

However, there is an important factor to consider: Any loans forgiven under these programs are considered taxable income by the IRS, which means that you could face a hefty tax bill when your loans are forgiven. In other words, after making payments under income-based repayment for 20 years, you’re left with $40,000 in debt. That $40,000 in forgiven debt could be considered taxable income.

In this case, your lender could send you a 1099-C form stating the amount of debt forgiven, which you’ll note when completing necessary tax forms such as the 1040.

So, though you may not have to pay $40,000 in student loans, you would still have a hefty tax bill. That $40,000 in loan forgiveness could bump your federal tax bill by thousands or tens of thousands of dollars — and that’s not accounting for potential state income taxes.

Although some states (such as Minnesota) have eliminated their tax bomb and others (such as Florida, Nevada and New Hampshire) don’t collect state income taxes, the amount you may end up paying is still significant.

Let’s say you’re filing your taxes as an individual. Your taxable income (not including loan forgiveness) is $50,000. Here’s your estimated income taxes:

Income by Tax BracketTax RateEstimated Income Taxes

In this scenario, your total estimated income taxes would be $6,859 — at an effective tax rate of 13.72%.

Now let’s include the $40,000 in loan forgiveness. With your taxable income now at $90,000, here’s a look at the estimated income taxes:

Income by Tax BracketTax RateEstimated Income Taxes

In this scenario, your total estimated income taxes would be $15,775 — at an effective tax rate of 17.53%. By having $40,000 in loans forgiven, your tax bomb would be $8,916. If you have more taxable income and a larger amount of loans are forgiven, you can see that your income taxes would rise pretty drastically.

If you can’t pay your tax bill, you’d be forced to set up a payment plan with the IRS to make payments toward your tax debt. If you don’t take any action, you could face a penalty and have to pay interest on this debt.

Possible changes to taxes on student loan forgiveness?

In 2016, U.S. Rep. Mark Pocan of Wisconsin sponsored the Underwater Student Borrowers Act. It proposes to allow student loan borrowers in good standing with their repayment to become exempt from being taxed on their forgiven loans.

Currently, loans forgiven through Public Service Loan Forgiveness, Teacher Loan Forgiveness and the National Health Service Corps Loan Repayment Program are exempt from being taxed, as are loans that are discharged if the student borrower becomes permanently disabled or dies.

Pocan’s bill didn’t make any progress — it was referred to a House committee the day it was introduced. However, since the student loan crisis continues to affect borrowers, changes may occur in the next few decades.

Some borrowers may still be able to claim insolvency to avoid paying taxes on student loan forgiveness. However, this likely only applies to a portion of borrowers who receive student loan forgiveness.

It’s crucial to understand current tax laws so that you can avoid major surprises in the future.

Larissa Runkle contributed to this report.