Student Loan Forgiveness Tax Bomb: What to Know Today

You might be aware of the student loan forgiveness tax bomb, if you’re on an income-driven plan. Each income-driven plan for federal loans has a maximum repayment period of 20 or 25 years, then any remaining balance is forgiven. This can be a borrower’s safe-haven if their balance is much greater than their annual income.

• SAVE: If you have eligible undergraduate loans, any remaining balance is forgiven after 20 years of qualifying repayment. However, if you owe less than $12,000, you'll receive forgiveness after 10 years. For eligible graduate or professional loan, any remaining balance is forgiven after 25 years of qualifying repayment on all of your loans.
• PAYE: Any remaining balance is forgiven after 20 years of qualifying repayment.
• IBR: Any remaining balance is forgiven after no more than 25 years of qualifying repayment.
• ICR: Any remaining balance is forgiven after 25 years of qualifying repayment.

BUT there’s a catch: In the Income-Driven Plan Request form to apply for one of these repayment plans, it clearly says “Forgiveness may be taxable.” Generally, canceled debt is treated as ordinary income, thus taxed at your marginal income tax rate during the tax year the debt is forgiven. Insert the dreaded tax bomb conversation.

Taxes on student loan forgiveness

The IRS tax code currently considers student loan forgiveness taxable. According to the IRS, nearly any debt you owe that’s canceled, forgiven or discharged becomes taxable income to you.

This means that after 20 or 25 years of qualifying repayment, if $600 or more is forgiven you'll be issued a 1099-C, “Cancellation of Debt,” from the lender that forgave the debt. This is a tax document you’d file at tax-time that year which results in you paying income taxes on the forgiven balance as if you’d earned it as income.

Student loan settlements can sometimes be offered on private student loans that are in default.

This is a bad scenario to be in, so I’m in no way suggesting this as a repayment strategy.

For purposes of taxes on this kind of student loan cancellation, any negotiated reductions in the outstanding loan balance will be considered as cancelled debt and will be taxable if over $600.

When loan forgiveness, cancellation, or discharge ISN’T taxable

Public Service Loan Forgiveness (PSLF): PSLF is carved into the tax code as being NOT taxable. Forgiveness is achieved after making the 120 qualifying payments. This is a huge advantage to PSLF, along with the much shorter timeframe to the forgiveness threshold.

Perkins loan forgiveness: Forgiven student debt from a Perkins is currently not taxable. Perkins loans aren’t issued anymore, but were lent by colleges and universities to folks with a high financial need. Borrowers are eligible for job-based loan forgiveness benefits. These jobs include educators, police officers, and other public service and health professionals.

Disability discharge: This type of loan discharge used to be taxable until our most recent tax-code overhaul in 2018. Borrowers who are totally and permanently disabled as defined by the Social Security Administration, Veteran’s Affairs, or a qualified physician, can get 100% of their federal loans discharged, tax-free.

The statute that changed the taxability of disability discharge is set to expire at the end of 2025. Congress would need to renew this statute to make it permanent.

Death discharge: Forgiveness through death discharge is similar to a disability discharge, in that it used to be a taxable event, but is now tax-free. The death of a borrower or a child the loan was borrowed for (for example, via a Parent PLUS loan) is currently a 100% dischargeable event and tax-free. However, taxability for this program could change after 2025.

Borrowers Defense to Repayment: You can apply for this forgiveness option, if you were a victim of unfair, deceptive, or illegal school practices. From the U.S. Department Of Education Borrower Defense To Repayment Application: 

“The most common types of conduct that might make a borrower eligible for loan relief through borrower defense to repayment discharge are misrepresentations of the truth made by the school or its representatives during their efforts to recruit you to enroll at the school or to continue your enrollment at the school. These misrepresentations typically take the form of untruthful representations of the school's selectivity in admitting students, its rankings as compared to other schools, the job placement and earnings outcomes of its prior graduates, or the likelihood that its credits will be accepted by another school or that it will accept credits from other schools.”

Should you go the income-driven forgiveness route?

There are really two paths to tackle student loan debt:

1. Aggressive. Get the lowest interest rate you can to pay off your loans, sooner rather than later.
2. Passive. Leverage the income-driven repayment plan that gives you the lowest payment, keep your adjusted gross income low, and maximize loan forgiveness and your savings.

Anyone who does the “murky middle” road ends up paying more out of pocket than necessary, because they’re not leveraging benefits like forgiveness, and not being as cost efficient with a consistent plan.

People with a 1.25 to 1.5x ratio of student loans or less to income might do best to take the aggressive approach. Those with 1.5 to 2x ratio or more might do better taking the passive approach, even if we need to save for the tax bomb. Test the numbers yourself by using our free student loan forgiveness calculator.

Changes to student loans during the Biden Administration

Payment and interest extension

President Biden extended the 0% interest and payment pause until September 30, 2023, which meant folks pursuing forgiveness continued to get credit toward their timeline without having to make a payment!

Loan cancellation

Biden has been clear about wanting to make changes overall to student loans. Initially, there’s been lots of talk about student loan cancellation. We talk about how this is a smoke screen for the bigger underlying problem: the cost of college education.

Either way, there's been a big battle on this in Congress and at the Supreme Court level since Senate Republicans still oppose student loan cancellation. I’m not holding my breath.

Automating IDR enrollment and recertification

The Biden administration has made many changes and improvements to the student loan system, including streamlining studentaid.gov, improving PSLF’s paperwork, payment tracking, and changing payment frequency requirements. Borrowers can also now automatically recertify for income-driven repayment by providing consent for the Department of Education to use federal tax return information directly from the IRS each year.

Lower payments for undergraduate loans

Undergraduate borrowers will be able to reduce monthly payments down to only 5% of discretionary income starting in July 2024 under the new SAVE plan. These actions could help make payments even more affordable, and could make pursuing the maximum repayment period forgiveness easier.

Student loans in bankruptcy

There’s been talk and possible bipartisan support of making student loans (more) dischargeable in bankruptcy. Discharging loans in bankruptcy isn't impossible, but it is challenging.

The reason is because student loans have a unique undue hardship standard to meet before they can be dischargeable in Chapter 7 or Chapter 13 bankruptcy.

PSLF improvements

Biden previously wanted to enable $10,000 of forgiveness each year of qualifying public service work up to five years. This is different from the current program where after 120 monthly payments (10 years, if consistent), the remaining balance is forgiven This change would allow folks with lower student loan balances to reap the benefit of forgiveness who otherwise wouldn’t have benefited since their loans would be fully paid before hitting 120 payments.

However, the Biden administration pushed through the PSLF Waiver (expired October 2022) and the IDR Waiver (expiring June 30, 2024), which has allowed millions of borrowers to receive forgiveness or be propelled forward in their student loan forgiveness journey.

The big one: tax-free student loan forgiveness

As mentioned before, forgiveness on an income-driven repayment plan after 20 or 25 years is currently taxable. Biden wants to change this and make student loan forgiveness tax-free. This would be huge!

This might be the biggest positive impact for borrowers with the least impact on our nation's budget, because this tax revenue isn’t even something the IRS is collecting on yet. The earliest we’ll see this should be 2032 for those who could’ve been on an IDR plan since 2012. Possibly earlier for those who’ve been on ICR, consistently.

What if the tax-bomb does not go away?

Knowing that the tax implication still exists now, we recommend that folks save for this until we have confirmation otherwise.

Our calculator helps you estimate what your future tax liability might look like, based on your balance and your income assumptions projected over time toward forgiveness. That number might have a shock factor, but you’ll want to break it up into bite-size pieces to see how much money you should save monthly. This will make the burden much less intimidating.

Feel overwhelmed? We can help. Schedule a consultation with us for your customized student loan repayment plan.