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Student Loan Forgiveness Tax Bomb, Explained

By Jennifer Calonia · December 08, 2022 · 5 minute read

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Student Loan Forgiveness Tax Bomb, Explained

Although student loan forgiveness provides repayment relief for borrowers saddled with student debt, there might be “tax bomb” to prepare for. The IRS code states that your loan forgiveness benefit might count as taxable income, depending on the type of forgiveness program you participated in. If your situation isn’t tax-exempt, you might be liable for a “tax bomb” in the tax year you received forgiveness.

President Biden recently announced that student loan borrowers may be eligible for up to $20,000 in loan forgiveness. While this amount won’t be taxed federally, some states may require borrowers to pay income tax on the forgiven amount. Continue reading for more information on different loan forgiveness situations and when they may incur taxes.

What Is the Student Loan Forgiveness Tax Bomb?

In addition to Biden’s recently announced forgiveness options, it’s possible for borrowers with federal student loans to pursue loan forgiveness by enrolling in an income driven repayment plan or pursuing forgiveness programs like Public Service Loan Forgiveness. This forgiven amount may or may not be considered taxable income.

Under the IRS rules, the amount of student loan debt that is forgiven may be considered taxable unless it is forgiven under a program or cancellation that is explicitly exempt. Forgiven amounts that are taxable are treated as earned income during the fiscal year it was received. Your lender might issue tax Form 1099-C to denote your debt cancellation.

So let’s say you earned $75,000, and received $15,000 in loan forgiveness, your total taxable income according to the IRS is $90,000. An increased income might raise you to a higher tax bracket which might cause your tax liability to go up.

How much you can expect to pay depends on a variety of factors, including the amount of debt that was forgiven, and your personal financial information. Speak to a tax professional to determine your potential tax liability.

Student loan forgiveness is available for borrowers with federal student loans. Generally, private student loan forgiveness isn’t an option.

Recommended: Guide to Student Loan Forgiveness

Steps to Take to Prepare for the Student Loan Tax Bomb

If you’re anticipating a student loan tax bomb after receiving loan forgiveness, there are a few steps you can take today to get ready.

Estimate Your Bill

The first step when bracing for a student loan forgiveness tax bomb is calculating how much you might owe come tax season. This factor can be influenced by factors including the type of forgiveness you are receiving and the forgiven amount.

To avoid sticker shock, you can use a student loan forgiveness tax bomb calculator, like the Loan Simulator on StudentAid.gov. It lets you see how much of your student loan debt might be forgiven, based on your projected earnings.

Choose the Right Plan

Enrolling your federal student loans into an income-driven repayment (IDR) plan can help you keep your monthly payments to a manageable amount while you’re awaiting loan forgiveness. There are four IDR plans available: Pay As You Earn, Revised Pay As You Earn, Income-Contingent Repayment, and Income-Based Repayment.

All of these repayment plans calculate your monthly payment, based on your income and family size. Depending on your situation, you might be eligible for a $0 monthly payment.

Other federal repayment plans such as the standard 10-year repayment plan generally do not qualify for loan forgiveness programs.

Recommended: REPAYE vs PAYE: What’s the Difference?

Prioritize Saving

If you’re expecting loan forgiveness in the future, it might be advantageous to allocate extra cash flow toward a dedicated tax bomb savings fund. Incrementally setting money aside over multiple years can ease the burden of a sudden lump sum tax bill down the line.

Who Faces a Student Loan Tax Bomb?

Although not all borrowers who receive federal student loan forgiveness will be hit with an additional tax liability, some borrowers will.

Income-Driven Repayment Tax Bomb

Borrowers who received loan cancellation after participating fully in an income-driven repayment plan can generally expect to pay taxes. Borrowers can apply for an IDR plan which lowers their monthly payment amount.

After successfully making 20 or 25 years of payments under an IDR plan, your remaining eligible federal student loan debt is forgiven. However, the amount that’s canceled typically counts as income that you’ll have to pay taxes on. There are a few exceptions such as for programs like Public Service Loan Forgiveness.

Potential Recipients of $10K of Student Debt Forgiveness, Possibly

Although the Student Loan Forgiveness Act under the Obama Administration fell through in committee, the Department of Education has since approved nearly $6 billion in student loan discharge for borrowers who were defrauded by Corinthian College.

In August 2022, the Biden Administration announced plans to cancel $10,000 per eligible borrower, up to $20,000 for those who received Pell Grants. This loan relief would be tax-free on a federal level. In some states, borrowers may be required to pay state income taxes on the forgiven amount.

Who Does Not Face a Student Loan Tax Bomb?

Certain federal student loan borrowers might not have to worry about an impending student loan forgiveness tax bomb, particularly those who receive cancellation through the Public Service Loan Forgiveness program (PSLF).

PSLF Tax Bomb

Participants of the Public Service Loan Forgiveness program don’t have to worry about a PSLF tax bomb. To earn PSLF forgiveness, borrowers are required to work for a government entity or nonprofit organization full-time while making 120 qualifying payments under an IDR plan. The program explicitly states that earned forgiveness through PSLF is not considered taxable income.

Paying for a Student Loan Tax Bomb

If you can’t afford to cover an increased tax debt due to a student loan forgiveness tax bomb, contact the IRS to discuss your options. Inquire about payment plans that can help you pay smaller tax payments over a longer period of time. However, be aware that fees and interest will likely accrue.

Diffusing the Student Loan Forgiveness Tax Bomb

Borrowers who receive loan forgiveness in any year from 2021 to 2025 will receive their forgiveness benefit tax-free. This includes forgiveness under income-driven repayment plans which is typically deemed taxable income.

And as mentioned, the up to $10,000 in student loan forgiveness announced by the Biden Administration will not be taxed at a federal level. Depending on where you live, you may be required to pay state income taxes on the forgiven amount.

The Takeaway

The student loan forgiveness tax bomb generally doesn’t apply to forgiveness or cancellation programs wherein you completed a mandatory service, like PSLF. However, a tax bomb could be a reality for you after 2025 if you receive forgiveness through IDR, or through future forgiveness legislation that’s taxed. Consider setting aside funds now to help you manage a potential tax bomb later.

If you need immediate relief from your student loans now, refinancing your loan might reduce your overall out-of-pocket expense by saving you money on your total interest. Note that refinancing federal student loans eliminates them from all federal forgiveness and relief programs.SoFi student loan refinance rates may be fixed or variable refinancing rates and flexible terms.

Find out if you prequalify to refinance student loans with SoFi in just a few minutes.

FAQ

Is loan repayment considered taxable income?

If your employer offers loan repayment assistance benefits, it would typically be considered taxable income. However under the CARES Act, loan forgiveness payments — and employer assistance loan payments up to $5,250 — made each year from 2021 through 2025 are tax-free.

Will refinancing my student loans help me avoid a tax bomb?

Student loan refinancing simply involves reworking one or more existing student loans into a new private loan that might offer a competitive interest rate and/or favorable terms. It’s a repayment strategy wherein you’re repaying your loan so a tax bomb doesn’t apply to any potential savings involved in this situation. Keep in mind that refinancing federal student loans eliminates them from any federal forgiveness programs.


Photo credit: iStock/fizkes

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SoFi Student Loan Refinance
If you are looking to refinance federal student loans, please be aware that the White House has announced up to $20,000 of student loan forgiveness for Pell Grant recipients and $10,000 for qualifying borrowers whose student loans are federally held. Additionally, the federal student loan payment pause and interest holiday has been extended beyond December 31, 2022. Please carefully consider these changes before refinancing federally held loans with SoFi, since the amount or portion of your federal student debt that you refinance will no longer qualify for the federal loan payment suspension, interest waiver, or any other current or future benefits applicable to federal loans. If you qualify for federal student loan forgiveness and still wish to refinance, leave unrefinanced the amount you expect to be forgiven to receive your federal benefit.

CLICK HERE for more information.


Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income-Driven Repayment plans, including Income-Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.


Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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