What's the Student Loan Forgiveness Tax Bomb?

Find out how you could end up with a large tax bill and how to prepare now. (iStock)

If you’re confused about what a student loan forgiveness tax bomb is, think of the term as a mixed blessing. On the one hand, the government forgives your student loans, but on the other hand, the government makes you liable for a hefty tax bill on the amount of money that’s forgiven. That’s because the forgiven debt is treated as additional income.

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With student loans topping more than $1.4 trillion in the U.S., more borrowers are depending on loan forgiveness programs to help erase some of their mounting debt. While the thought of having your debt disappear seems like a no-brainer, many students and their parents are caught off guard once the tax bill rolls around. Taxes on that forgiven debt are not erased and it’s mandatory that you report it to the IRS as income.

Who faces a student loan forgiveness tax bomb?

As April 15 approaches, it’s worth discussing who’s really at risk for a student loan forgiveness tax bomb down the road so there are no surprises. Borrowers struggling to make payments often lean toward an income-driven repayment plan. These plans help when your monthly debt surpasses your monthly income.

WHAT QUALIFIES YOU FOR STUDENT LOAN FORGIVENESS?

With income-driven repayment plans, you’re able to make very low payments for 20 or 25 years, based on the amount of money you’re making. But a little realized fact is that borrowers enrolled in income-driven repayment plans are also most likely to be hit with the surprise, oversized tax bill. Once the repayment time frame ends, the remaining balance is forgiven, and at the same time it is considered as taxed income.

You'll likely have a student loan tax bomb if:

  • You enrolled in an income-driven repayment plan.
  • You did not pay-off your full balance within the allotted time.

You'll likely not have a student loan tax bomb if:

  • Your employer forgives your loans through one of several programs based on your current industry. Numerous programs don’t apply a tax to the forgiven debt. This includes the Teacher Loan Forgiveness program, the Public Service Loan Forgiveness program, and the National Health Service Corps Loan Repayment Program.
  • You have a Perkins Loan that was canceled based on either your employment or volunteer service or because of other conditions. Those forgiven loans are not subject to tax bills.
  • You were the victim of a scam or fraud by your educational institution or if the college shut its doors for good.
  • You become permanently disabled or pass away.

How much will I have to pay?

While what you will be expected to pay will vary based on your loan amount, the remaining balance, and your current income at the time, the following example gives you a good idea of how the tax bomb works:

Say a borrower makes $60,000 per year. That same borrower qualifies to have $100,000 of loans forgiven through one of the programs. Prior to the loan forgiveness income, his federal income tax amounted to $9,140.

HOW STUDENT LOANS CAN AFFECT YOUR CREDIT SCORE

However, after his $100,000 of loan forgiveness, his federal income tax ballooned to $32,980. That’s because the additional income pushed him into a higher tax bracket. That amounts to a huge tax increase, aka bomb, that he may not have been expecting.

Check with a tax professional to see if your state taxes will be impacted as well, since those may vary.

How to prepare for a forgiveness tax bomb

If you know you will be hit with a student loan forgiveness tax bomb, don’t fret because planning now will save you frustration down the line. Here are some ways you can plan so you don’t get caught off guard when it’s time to pay the IRS.

  • Check out this handy repayment calculator to get a good idea of how much your student loan payments could be as well as the total forgiveness amount.
  • Start squirreling away money now. Even just $25 a month will go a long way in helping to start long-term savings when that IRS bill becomes due. This is especially true since you have a good 20 years or so to prepare and save. At that amount, you will have $3,000 saved after 10 years and $6,000 after 20 years.

Options for when you can’t afford to pay the bill

If the tax bill comes before you’re prepared to pay, you can set up a payment plan with the IRS. There will be interest to pay on the plan, but it’s better than the alternative if you don’t have the funds.

It’s also worth noting that more companies are recognizing the problem of student loan debt impacting their employees. If you’re lucky enough to work for a company that helps with student loan payments, be sure and take advantage of the program. If you’re in the market for a job, you may want to keep your eye on companies that provide student loan repayment benefits.

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