If you’re facing a hefty student loan balance, then you may have already considered pursuing student loan forgiveness to avoid repaying your loans.
But you might not know: Student loan forgiveness is often taxable.
These taxes can create huge hidden costs when the forgiven amount gets added to your tax bill.
Here’s what you should know about student loan forgiveness and taxes before you’re surprised with a tax bill.
You Could Be Hit With a Tax Bill
For many borrowers, income-driven repayment plans, such as Pay As You Earn, coupled with student loan forgiveness, can be financial saviors. These repayment plans cap your student loan payments each month at 10% to 15% of your income.
After some period—usually 20 to 25 years—of steady repayment, your remaining balance is forgiven.
However, there is an important factor to consider: Under current IRS rules, any loans forgiven under these programs are considered taxable income.
This means you could face a hefty tax bill when your loans are forgiven.
Let’s say that after making payments under an income-driven repayment plan for 25 years, you’re left with $40,000 in debt, which is forgiven. That $40,000 becomes taxable income.
In this case, your lender would send both you and the IRS a 1099-C form with the amount of debt forgiven—the same amount you’ll use when completing the necessary tax forms.
So while you might no longer have to pay back $40,000 in student loans, you’ll instead owe a big tax bill. That $40,000 in loan forgiveness could mean a $10,000-plus federal tax bill, which doesn’t include potential state income taxes.
If you can’t pay the tax bill, you could be forced to set up a payment plan with the IRS to resolve your tax debt. If you don’t take any action, you could face a penalty and have to pay interest on this debt.
And you thought your student lender was tough — imagine dealing with the IRS.
Possible Changes to the Current Tax Law
Lawmakers have discussed changing tax laws to get rid of the prospect of paying massive tax bills on student loans. Last year, U.S. Reps. Mark Pocan and Frederica Wilson introduced the Relief for Underwater Student Borrowers Act.
This act would exempt student loan borrowers in good standing with their repayment from being taxed on their forgiven loans.
Currently, only borrowers who qualify for forgiveness as a result of their jobs (e.g. teacher loan forgiveness or public service student loan forgiveness) are exempt from being taxed.
Pocan said the bill is important because it “closes a major gap in our tax code which penalizes some borrowers who have been granted debt relief after at least 20 years of consistent repayment towards their student loan debt.”
However, the bill has made little headway in Congress. Meanwhile, the student loan crisis continues to affect borrowers.
In the absence of a legislative fix, some borrowers can claim insolvency to avoid paying taxes on forgiveness. However, this likely only applies to a portion of borrowers who receive student loan forgiveness.
The laws may yet change as more people start to have their loans forgiven.
In the meantime, it’s crucial to understand the current tax law so that you can avoid unpleasant surprises in the future.
It’s also a good idea to see how your student loan is affecting your credit score. If you’re paying them back on time, it’s a way to boost your scores while you’re young. You can check two of your scores free, updated every 14 days, on Credit.com.
The post Here’s When You’ll Owe Taxes on Forgiven Student Loans (& When You Won’t) appeared first on Credit.com.