Student loan forgiveness can be a great relief for borrowers who are struggling to repay their debt. However, it can also come with a hidden cost: taxes. Depending on the type and timing of your student loan forgiveness, you may have to pay federal or state income taxes on the amount of debt that is canceled. Here are some things you need to know about taxes on student loan forgiveness.
Federal Taxes on Student Loan Forgiveness
The Internal Revenue Service (IRS) generally considers canceled debt, including student loan forgiveness, to be taxable income. This means that you may have to report the amount of debt that is forgiven on your federal tax return and pay taxes on it at your marginal tax rate.
However, there is a temporary exception to this rule thanks to the American Rescue Plan Act of 2021, which was signed into law by President Biden in March 2021. This law excludes any student loan forgiveness from federal income taxes for loans that are discharged between January 1, 2021 and December 31, 2025. This applies to all types of student loan forgiveness programs, including:
- Income-driven repayment (IDR) plans: These are repayment plans that adjust your monthly payments based on your income and family size. After 20 or 25 years of repayment, depending on the plan, any remaining balance is forgiven.
- Borrower defense to repayment: This is a program that allows you to apply for loan discharge if your school misled you or violated certain laws related to your education or loans.
- Closed school discharge: This is a program that allows you to apply for loan discharge if your school closed while you were enrolled or within 120 days after you withdrew.
- Total and permanent disability discharge: This is a program that allows you to apply for loan discharge if you are unable to work due to a physical or mental impairment that is expected to last at least five years or result in death.
- Death discharge: This is a program that cancels your student loans if you die.
- Teacher loan forgiveness: This is a program that forgives up to $17,500 of your federal loans if you teach full-time for five consecutive years in a low-income school or educational service agency.
- Public service loan forgiveness (PSLF): This is a program that forgives the remaining balance of your federal loans after you make 120 qualifying monthly payments while working full-time for a qualifying employer, such as a government agency or a non-profit organization.
The American Rescue Plan also instructs student loan servicers not to issue Form 1099-C to borrowers who qualify for the tax exclusion. This form is usually used to report canceled debt to the IRS and the borrower.
However, this tax relief is only temporary and will expire after 2025. Unless Congress extends it or makes it permanent, any student loan forgiveness that occurs after December 31, 2025 will be subject to federal income taxes, except for PSLF, which is always tax-free.
State Taxes on Student Loan Forgiveness
While the American Rescue Plan excludes student loan forgiveness from federal income taxes until 2025, it does not affect state income taxes. Each state has its own tax laws and rules regarding canceled debt, and some states may not conform to the federal law.
As of November 2021, five states are projected to tax student loan forgiveness: Arkansas, Minnesota, Mississippi, North Carolina and Wisconsin. Indiana also confirmed that forgiveness will trigger state and county income taxes. Some other states, such as California and Wisconsin, are still reviewing their tax laws and have not made a final decision yet.
If you live in a state that taxes student loan forgiveness, you may have to report the amount of debt that is forgiven on your state tax return and pay taxes on it at your state tax rate. You may also receive Form 1099-C from your student loan servicer for state tax purposes.
How to Prepare for Taxes on Student Loan Forgiveness
If you are pursuing or expecting student loan forgiveness, you should be aware of the potential tax implications and plan ahead for them. Here are some tips to help you prepare for taxes on student loan forgiveness:
- Check your state tax laws: Find out if your state conforms to the federal law regarding student loan forgiveness or has its own rules. You can check with your state’s department of revenue or consult a tax professional for guidance.
- Save money for taxes: If you expect to owe taxes on your student loan forgiveness, either at the federal or state level, you should start saving money for them as soon as possible. You can estimate how much you will owe by multiplying the amount of debt that will be forgiven by your marginal tax rate. You can also use online calculators or tools, such as NerdWallet’s Tax Calculator, to get a more accurate estimate.
- Consider other options: If you are worried about the tax bill from student loan forgiveness, you may want to consider other options to reduce or eliminate your debt, such as refinancing your loans, consolidating your loans, making extra payments or applying for other forms of relief or assistance. You should weigh the pros and cons of each option and compare them with the benefits and costs of student loan forgiveness.Set featured image
Bottom Line
Student loan forgiveness can be a great way to get rid of your debt, but it can also come with a tax bill. Depending on the type and timing of your student loan forgiveness, you may have to pay federal or state income taxes on the amount of debt that is canceled. You should be aware of the tax rules and consequences of student loan forgiveness and plan ahead for them. You should also explore other options to manage your debt and consult a tax professional if you have any questions or concerns.