If you’re facing a hefty student loan balance, then you may have already considered pursuing student loan forgiveness to avoid having to pay back your loans.
But what you might not know is this: student loan forgiveness is taxable in many situations.
These taxes can create huge hidden costs when this forgiveness amount gets added to your tax bill.
Here’s what you should know about student loan forgiveness and taxes before you’re surprised with a tax bill
You Could Be Hit with a Tax Bill
For many borrowers, Income-Driven Repayment plans, such as Pay As Your Earn, coupled with student loan forgiveness can be financial saviors. These repayment plans cap your student loan payments each month at 10–15% of your income.
After some period—usually 20–25 years—of steady repayment, your remaining balance is forgiven.
However, there is an important factor to consider that’s rarely discussed. Even when it is mentioned, it seems to be only an afterthought or a clause in the fine print:
Under current Internal Revenue Service (IRS) rules, any loans forgiven under these programs are considered taxable income.
In short, this rules means that you could face a hefty tax bill when your loans are forgiven.
Let’s say that after making payments under IBR for 25 years, you’re left with $40,000 in debt. That $40,000 in forgiven debt would be considered taxable income.
In this case, your lender would send both you and the IRS a 1099-C form, stating the amount of debt forgiven—the same amount you’ll use when completing the necessary tax forms.
So, though you may not have to pay $40,000 in student loans, you would still have a hefty tax bill to pay. That $40,000 in loan forgiveness could mean a $10,000+ federal tax bill, and that doesn’t include potential state income taxes.
Of course, many variables determine your tax rate, but getting your loans forgiven could lead to a remarkably surprising tax bill.
If you can’t pay the tax bill, then you’d be forced to set up a payment plan with the IRS to make payments towards your tax debt. If you don’t take any action, then you could face a penalty and have to pay interest on this debt.
In another sense, if you dislike your student loan lender, then I imagine that you won’t be too fond of dealing with the IRS, either.
Possible Changes to the Current Tax Law
In light of the grim prospect of paying a massive tax bill on your student loans, discussions about changing the current tax law have been held. Last year, US Representatives Mark Pocan and Frederica Wilson introduced the Relief for Underwater Student Borrowers Act.
This act proposes to allow student loan borrowers in good standing with their repayment to become exempt from being taxed on their forgiven loans.
Rep. Mark Pocan argues that the bill is important because it “closes a major gap in our tax code which penalizes some borrowers who have been granted debt relief after at least 20 years of consistent repayment towards their student loan debt.”
Despite discussions about reversing the current tax law, the bill has not yet been passed. However, since the student loan crisis continues to affect borrowers, sweeping changes may yet occur during the next few decades.
Despite the lack of changes, some borrowers still may be able to claim insolvency to avoid paying taxes on forgiveness. However, this likely only applies to a portion of borrowers who receive student loan forgiveness.
Of course, we can’t say what things will look like in 20 or 25 five years from now, when people start to have their loans forgiven.
In any case, it’s crucial to understand the current tax law so that you can avoid major surprises in the future.
To stay updated, continue to follow our blog for the latest information on student loan reform.
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