Navigating the Maze of Student Loan Forgiveness Taxes
The student loan landscape is in a state of flux. After a three-year hiatus, federal student loan payments are set to resume in October 2023, leaving borrowers facing the daunting task of repaying their debts. While President Biden’s $9 billion relief plan offers a lifeline to some borrowers, others may be wondering about the potential tax implications of student loan forgiveness.
The Evolving Landscape of Student Loan Forgiveness
In 2020, the U.S. Department of Education suspended federal student loan payments and set interest rates to 0% in response to the COVID-19 pandemic. This provided much-needed relief to millions of borrowers, but the suspension is set to expire on October 1, 2023.
In an effort to provide further relief, President Biden announced a one-time student loan forgiveness plan in August 2022. Under this plan, eligible borrowers could receive up to $10,000 in federal student loan forgiveness, and Pell Grant recipients could receive up to $20,000. However, the plan was blocked by a federal judge in November 2022, and the Supreme Court declined to overturn the decision in June 2023.
Despite these setbacks, President Biden has secured a $9 billion plan that will extend relief to 125,000 borrowers across the U.S. This plan includes borrowers enrolled in Public Service Loan Forgiveness programs, income-driven repayment plans, or those approved for discharge through the Social Security Administration due to total or permanent disability.
The Tax Implications of Student Loan Forgiveness
While student loan forgiveness offers a glimmer of hope for struggling borrowers, it’s crucial to recognize that this relief may come with tax implications. The Internal Revenue Service (IRS) considers canceled debt, including most forms of student loan forgiveness or discharge, as taxable income.
Temporary Tax Relief Under the American Rescue Plan Act of 2021
Borrowers pursuing loan forgiveness enjoyed a brief respite from taxes, thanks to the American Rescue Plan Act of 2021. This measure exempted forgiven student loans from federal income taxes, but its applicability was limited to loans discharged between January 1, 2021, and December 31, 2022.
The American Rescue Plan’s reach extended to all student loan forgiveness programs, but its impact was confined to federal income taxes. While some states adopted similar measures for state income taxes, others did not follow suit.
Navigating State Tax Laws for Student Loan Forgiveness
As of 2023, Indiana, North Carolina, and Mississippi have declared that forgiven student loan balances will be taxed as income. Taxpayers in Arkansas, California, and Wisconsin could potentially face the same fate, as these states are currently reviewing their tax laws and have yet to make a definitive determination.
It’s worth noting that a previous version of this article erroneously included Minnesota among the states that would tax forgiven student loan balances as income. However, recent legislative action in Minnesota has amended their tax laws to permanently adopt the American Rescue Plan Act exclusion for discharged student loans, effective for taxable years beginning after December 31, 2022.
Tax Consequences of Student Loan Forgiveness After 2025
The American Rescue Act’s provisions regarding student loan forgiveness taxes will expire on December 31, 2025. From January 1, 2026 onward, the tax treatment of student loan forgiveness and discharge programs will vary depending on the program.
Public Service Loan Forgiveness (PSLF)
Borrowers who have dedicated their careers to non-profit organizations, government agencies, or public service groups may qualify for PSLF. This program offers debt cancellation after 10 years of full-time employment and 120 qualifying monthly payments. PSLF stands out as one of the few programs where the forgiven loan amount is not subject to federal income taxes.
Income-Driven Repayment (IDR) Discharge
IDR plans cater to federal loan borrowers who struggle to meet their payments under the standard 10-year repayment plan. These plans extend loan terms and base monthly payments on a percentage of the borrower’s discretionary income. The four IDR plans are:
- Income-Based Repayment
- Income-Contingent Repayment
- Pay As You Earn
- Revised Pay As You Earn
While IDR plans provide relief during the repayment period, the forgiven loans at the end of the loan term are taxable as income at both the federal and state levels.
Borrower Defense to Repayment Discharge
Borrowers who have been misled by their colleges or have attended institutions that engaged in misconduct and violated state laws may be eligible for Borrower Defense to Repayment Discharge. This program eliminates federal student loans for affected borrowers.
The IRS and the U.S. Department of the Treasury have clarified that loans discharged through Borrower Defense to Repayment are not taxable as income.
Total and Permanent Disability Discharge (TPDD)
Borrowers who become totally and permanently disabled may qualify for TPDD. This program discharges the remaining loan balance for eligible federal loan borrowers.
The tax treatment of TPDD depends on the timing of the discharge:
- Discharges before January 1, 2018: Subject to federal income taxes
- Discharges between January 1, 2018, and December 31, 2025: Exempt from federal income taxes
- Discharges in 2026 and beyond: Tax treatment is currently unclear
Taxation of Private Student Loan Forgiveness
Private student loans are not eligible for federal loan programs like PSLF or TPDD. However, borrowers with private student loans may qualify for other loan forgiveness or discharge programs offered by their lenders. For example, some private lenders may discharge loans for borrowers who become totally and permanently disabled.
The American Rescue Plan also exempts forgiven private student loans from federal income taxes through the end of 2025. However, they may still be subject to state income taxes.
Frequently Asked Questions
Can I Reduce My Tax Bill by Paying Down My Loan Balance?
Technically, you can reduce your tax bill by paying down your loan balance before a loan discharge after 2025. However, this strategy may not be feasible for all borrowers, especially since taxable programs consider your income. Paying down the debt may result in higher payments in the future, potentially diminishing the effectiveness of the forgiveness program.
How Can I Estimate My Tax Liability Due to Student Loan Forgiveness?
To estimate your tax liability due to student loan forgiveness, you can use the American Institute of CPAs marginal tax rate calculator. This tool provides a ballpark figure of how much you might owe, allowing you to plan accordingly. If you anticipate a substantial tax bill, consider setting aside a portion of your income in a high-yield savings account or CD to prepare for the potential tax liability.
What Happens if Congress Extends the American Rescue Plan Past 2025?
If Congress extends the American Rescue Plan past 2025, borrowers seeking loan forgiveness through IDR discharge, TPDD, and private loan forgiveness programs would be exempt from federal income taxes. Since PSLF is never taxed as income, any extensions would not affect its tax treatment.
Conclusion
Navigating the complexities of student loan forgiveness and its tax implications can be daunting. However, with careful planning and consideration, borrowers can take steps to minimize their tax liability and maximize the benefits of student loan forgiveness. It’s important to stay informed about changes in the law and to consult with a tax professional if you have specific questions or concerns.