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  5. Can Debt Forgiveness Cause a Student Loan Tax Bomb?

Can Debt Forgiveness Cause a Student Loan Tax Bomb?

Updated for Tax Year 2020 / May 3, 2021 09:47 PM


OVERVIEW

People who benefit from student loan forgiveness may be wondering about the tax consequences of this debt relief option, including a potential "student loan tax bomb." Your student loan repayment choice can prevent or cause this situation.


For information on the third coronavirus relief package, please visit our “American Rescue Plan: What Does it Mean for You and a Third Stimulus Check” blog post.


 

Student loan forgiveness is a much-debated issue for Americans who carry debt taken on for attending college. While you may benefit from loan forgiveness by having less money to repay down the road, your finances may still take a short-term hit from an unlikely source: a student loan tax bomb. This is especially the case for borrowers on income-driven repayment plans who aren’t part of qualifying federal student loan forgiveness programs.

Thankfully, lawmakers may have a way to protect borrowers unable to afford this tax bill. Learn more about a possible student loan tax bomb, loan forgiveness, and how to combat this tax hit.

What is a student loan "tax bomb"?

A "student loan tax bomb" occurs when your student loan lender forgives all or a portion of your debt, causing you to include this amount in your taxable income.

Generally, the IRS taxes all income sources. When a creditor cancels, forgives, or discharges a debt, they erase some or all of the amount from your outstanding balance. The amount forgiven is typically includable in your gross income and subject to income taxes. You'll report this balance on Form 1099-C, Cancellation of Debt.

How can student loans be forgiven?

Loan forgiveness means you no longer need to repay some or all of your outstanding loan balance. You can qualify for loan forgiveness if you meet specific eligibility criteria and follow all the rules set out in government loan plans like the Public Service Loan Forgiveness or the Teacher Loan Forgiveness programs.

Under most federal student loan programs, if you follow the rules and make all of your payments, the forgiven balance will likely be tax-exempt.

You can also have your student loans forgiven if you repay them under an income-driven repayment plan. This requires you to make monthly payments in proportion to your discretionary income, usually over 20 or 25 years. Any remaining balance after this period will be forgiven and likely considered taxable income.

The COVID-19 pandemic has also brought about federal student loan relief, as the government decided to defer payments borrowers must make without accruing interest. The Department of Education initially suspended loan payments, quickly followed by an extension through September 30, 2020, with the passage of the CARES Act, and finally by an additional executive order extending the suspension through December 31, 2020.

A further executive order extended federal student loan payment deferment through September 30, 2021.

Situations that can cause a tax bomb

Forgiving a federal student loan balance, and the resulting tax bomb, primarily impacts borrowers who use income-driven repayment plans. These payment plans last for a set amount of time, typically 20 or 25 years, and require you to pay between 10% and 20% of your discretionary income until you repay the loan.

Any remaining balance after the payment plan ends gets forgiven. This forgiven amount can be considered taxable income in the year it occurs, depending on your repayment plan and loan program.

Situations that won't cause a tax bomb

If you receive loan forgiveness under federal student loan programs, it will likely count as a tax-exempt gain (or reduction in liability). You typically won't face a tax bomb from loan forgiveness in the following situations:

  • You successfully participate in a qualifying federal loan program. If you follow the rules of programs like Public Service Loan Forgiveness, Teacher Loan Forgiveness, and similar federal loan programs, any loan forgiveness you receive should not be taxable.
  • You pass away or become permanently disabled. If you die or become permanently disabled, neither you nor your estate will be hit with a tax bill for forgiven debt under federal student loan programs.
  • Your loan gets discharged on account of fraud or school closure during enrollment. The government grants tax-free loan forgiveness in instances where you took on student debt and were defrauded by your school or it closed while you were enrolled.

You might also qualify for state-level loan forgiveness programs that offer tax-free loan forgiveness. Research the possible loan forgiveness programs offered by your state and whether you may qualify for tax-exempt loan forgiveness. You may also want to consult with a tax professional.

How can I pay for a student loan tax bomb?

If you don't qualify for a federal student loan program offering tax-exempt loan forgiveness, you may need to account for how you can pay for your student loan forgiveness. This means calculating your income taxes with the loan forgiveness factored into your taxable income.

After you estimate your tax bill, you can prioritize saving the money you otherwise would have paid toward your forgiven loans. This will avoid a cash crunch posed by a student debt tax bomb.

For example, if you have enrolled in an income-driven repayment plan and can reasonably foresee your payments over the term won't result in complete loan repayment, you can estimate your eventual loan forgiveness tax bomb.

If you set aside $25 per month for 25 years in an account earning 2% compounding interest per year for your eventual tax payment, you'll have saved over $9,000 after taxes (assuming a 22% marginal income tax bracket). This amount can be used to offset your future student loan tax bomb.

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