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Can Debt Forgiveness Cause a Student Loan Tax Bomb?

Written by a TurboTax Expert • Reviewed by a TurboTax CPAUpdated for Tax Year 2024 • October 17, 2024 3:11 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.


Key Takeaways

  • If your student loan debt is forgiven, the forgiven amount might be considered taxable income, leading to a potential tax liability.
  • Borrowers on income-driven repayment plans should be aware that forgiven loans are reported as income unless they're part of qualifying federal forgiveness programs.
  • It's important to prepare for the possibility of a tax impact if you're anticipating loan forgiveness outside of these federal programs.
  • Understanding the specifics of your repayment plan and its implications on your taxes can help you avoid unexpected financial burdens.

Student loan forgiveness

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 unless a tax law specifically exclude it from taxable income. Your student loan lender will report a forgiven 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.

Additionally, student loans can be forgiven by the government enacting laws that specify the loans will be forgiven.

TurboTax Tip:

Always consult with a tax professional to understand how debt forgiveness could affect your tax situation and plan accordingly.

Coronavirus Relief for Student Loan Borrowers

The COVID-19 pandemic has 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 again by an additional executive order extending the suspension through December 31, 2022. After further delays, student loan payments resumed in October of 2023.

In addition to temporarily suspending payments, interest, and collection actions on defaulted loans, the CARES Act allows employers to make tax-free student loan payments on behalf of employees of up to $5,250 per employee each year from 2021 through 2025 (totaling up to $26,250).

Situations that can cause a tax bomb

Forgiving a federal student loan balance, and the possible 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 typically 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.
  • The government cancels your debt by an act of law or executive order.

You might also qualify for state-level loan forgiveness programs that offer tax-free loan forgiveness. If not, you might find that your loan forgiveness is taxable for state income tax even if not taxable for federal taxes. 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.

With TurboTax Live Full Service, a local expert matched to your unique situation will do your taxes for you start to finish. Or, get unlimited help and advice from tax experts while you do your taxes with TurboTax Live Assisted.

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~37% of filers qualify. Simple Form 1040 returns only (no schedules except for Earned Income Tax Credit, Child Tax Credit and student loan interest).

Looking for more information?

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

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