Student Loan Forgiveness Tax Bill: A Major Downside of Loan Forgiveness

As you may know, total outstanding student debt in the U.S. has reportedly ballooned to over $1.4 trillion, and as more and more students face the serious issue of rising debt, many rely on loan forgiveness programs which also has its downsides. Let’s walk you through it!

Taxation of Future Loan Forgiveness

Whether you qualify for the latest round of student loan forgiveness or anticipate benefitting from future cancellation, it’s always vital to plan for taxes.

While public service loan forgiveness has always been tax-free, the current taxation for income-driven repayment plans is only momentary.

Your lender expects you to repay your loans even if you do not complete your education, are unable to find a job related to your study program, or are dissatisfied with your loan education.

This is valid even if, when you assented to the promissory note or got the loan, you were a minor (under 18 years of age).

Types of Loan Forgiveness

Expanding further, loan forgiveness can come in two categories as explained below.

Public Service Loan Forgiveness

Federal forgiveness programs like Public Service Loan Forgiveness (PSLF) exclude the amount from taxable income, and you won’t have to claim it on your federal tax return.

Under this program, if you are employed by a non-profit organization and you meet the qualification requirements, then the amount of the forgiven loan is not considered taxable income.

To qualify for this treatment, the loan must have been made by:

The federal government, a state or local government, or an instrumentality, agency, or subdivision of one of those governments;
A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law; or
An educational institution: under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or as part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) (non-profit) organization.

Loan Forgiveness in the Private Sector

As mentioned above, you may be required to report the sums forgiven or canceled as taxable income. To better understand this, look at the Federal Tax Table for 2018.

This shows the new tax brackets* and contains two MAJOR bracket shifts: from 12% to 22%, and from 24% to 32%.

Your “tax bomb” could also cause you to shift into a significantly higher marginal tax bracket, a phenomenon known as “bracket creep,” depending on your income and the amount forgiven.

*Note that this only shows federal tax brackets; different states will have varying tax brackets, so be sure to factor your state income tax into the calculations.

Consider the following scenario: an individual reports taxable income after exemptions & deductions of $60,000, and has qualified for loan forgiveness in the amount of $100,000 (all figures are approximate).

The Downside of Student Loan Forgiveness Tax Bill

The consequence of forgiving, canceling, or discharging all or part of your loan may seem like a godsend. It also means, though, that you are likely to be forced to record that amount as income on your tax return.

Do note that tax implications apply for all loans forgiven under the Pay As You Earn Repayment Plan (PAYE), Revised Pay As You Earn (REPAYE), Income-based Repayment (IBR), and Income-Contingent Repayment Plan (ICR) after 20-25 years of payment.

Therefore, depending on the taxable income after loan forgiveness, you might receive a student loan redemption “tax bomb” of between 10% and 37% of the amount forgiven.

Until we try to calculate the potential tax owed on a loan forgiven or canceled, we should first discuss the possibility that all or part of the loan may not be taxable; these are described by the IRS as “exceptions” and “exclusions.”

IRS Report 4681 (2017), Loan Cancelations, Exclusions, Repossessions, and Abandonments addresses “Exceptions” and “Exclusions.” The most relevant parts will be summarized for the purpose of this report.

What are Exceptions?

Your lender will issue you an IRS Form 1099-C, which will report the amount of forgiveness if you have a loan forgiven.

This form will then be included in your tax return and will be included in your taxable income.

Generally getting a Form 1099-C, means you owe taxes on the amount, but there are situations where you are NOT required to owe taxes on the value of the forgiven student loan.

Sometimes a debt you don’t have to pay, or part of a debt, is not considered a canceled debt, and can qualify as an “exception.”

What are Exclusions?

There are several reasons why you may still be able to exclude it from your earnings after you have made any exceptions to your forgiven or canceled loan. As with exceptions, if your income lacks a debt that has been canceled or forgiven, it is non-taxable.

Nevertheless, in most situations, if you exclude this amount from taxes under one of these rules, you also need to minimize your “tax attributes” (some loans, expenses, and asset base). For a detailed discussion of tax characteristics, please refer to IRS Publication 4681.

Loan Forgiveness Due to Financial Hardship

Federal student loan borrowers who are unable to work as a result of illness or injury may have their loans forgiven or discharged as a result of full and permanent disability and may also prevent taxing the amount.

In one of three forms, lenders may qualify: with physician credentials, Social Security benefits, or Department of Veterans Affairs certification.

Recently, this last example made headlines in Michigan, when a disabled soldier forgave $223,000 in federal student loans, and then got a $62,000 tax bill instead. He turned for help to his state and congressional leaders.

A few months later, the Michigan Senate passed Senate Bill 642 to ensure that veterans with disabilities do not have to pay state income tax on student loan debt forgiven due to the injuries of the veteran.

Sadly, debt cancelation was still treated as income by the IRS, so he was asked to pay federal income tax on the whole amount, so the federal tax bill stayed at $62,000.

Yet Congress came to the rescue: debts repaid on or after January 1, 2018, are no longer recorded as taxable income due to “complete and permanent disability.”

The bad news is that the move is not retroactive, as part of a massive reform of the tax code outlined in the Tax Cuts and Jobs Act.

Tax Forgiveness Due to the Insolvency Exclusion

If you are not eligible for one of the above-mentioned relief options, then one of the only ways left to avoid a student loan discharge tax ramification is to apply for an exclusion from insolvency.

If his or her total liabilities surpass his or her total assets, a taxpayer becomes insolvent. To the degree that the taxpayer is insolvent, a taxpayer is not currently required to include forgiven debts in earnings.

Keep in mind that it may not be for the full amount of your loan repayment if you are eligible for an exemption from insolvency.

Keep in mind that these laws may also change. In order to apply for this exemption, you will need to complete IRS Form 982. You should estimate the exclusion price using the worksheet in IRS Publication 4681.

Are Retirement Accounts Protected from the IRS?

IRAs, self-employed plans like SEP-IRAs, and Keogh plans, the IRS will seize retirement accounts.

The trick to protecting IRS seizure retirement accounts is to recognize that the IRS “stands in your shoes,” which means the IRS can’t get to it either if you can’t get to the retirement money.

Most retirement plans provide for separate access to funds from service, retirement, or death/disability.

So if you’re still operating, you still don’t have the ability to withdraw the retirement money, so the IRS doesn’t have the ability to take it.

The Bottom Line

As a general rule, in order to get full loans forgiven, you can pay as little as possible and have as much leftover as possible.

You should also set up a bank account to make monthly deposits for future payments or unforeseen events to provide a buffer.

Eventually, you may be able to delay the year of repayment to one in which your tax bracket will be smaller, further mitigating the potential tax redemption bombs for student loans.

Ideally, this article has given you a better understanding of the tax consequences of loan forgiveness and provided you with some guidance and tactics to support you along the way. Manage your money carefully, as always, and prepare for contingencies.

Student Loan Forgiveness Tax Bill: A Major Downside of Loan Forgiveness