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The Guide to IDR Forgiveness and the Future Tax Bills


Staff member
Dec 14, 2023
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Out of the fire and into the frying pan: borrowers may face a huge tax bill after they finally earn student loan forgiveness. It’s often called the student loan tax bomb.

The good news is that this hefty tax is often avoidable.

Unfortunately, not all borrowers will dodge the student loan tax bomb. It is a significant drawback to forgiveness and something that any borrower pursuing loan forgiveness should understand.

Student Loan Tax Bomb Origins​

The origins of the significant tax bill on forgiveness can be traced to a single IRS rule.

The IRS treats forgiven debt as income in the year it was forgiven.

In many cases, this rule makes sense. If I work for Visa and Visa chooses to forgive my credit card debt as a bonus, it’s fair to tax that forgiveness as income.

Likewise, it wouldn’t be fair for employers to “loan” their employees’ money each week and then “forgive” it later to avoid taxes.

Student Loan Forgiveness Isn’t Taxed – For Now​

The good news for many borrowers is that student loan forgiveness is a notable exception to the rule taxing forgiven debt.

Sadly, this particular exception ends on January 1, 2026 for many types of student loan forgiveness. In other words, if you reach IDR forgiveness before 2026, you are in the clear. If you are making payments on the SAVE plan until 2029, there could be a large tax bill in your future.

PSLF Special Exception: Unlike IDR forgiveness, PSLF tax-free forgiveness is permanently written into the tax code.

If you expect to earn PSLF forgiveness in 2030, there won’t be a huge tax bill waiting.

The Rules After 2026 and Planning for the Worst​

Starting January 1, 2026, the temporary rules expire. At that point, forgiveness under income-driven plans like SAVE and IBR gets taxed.

While 2026 may seem like a long way away, many borrowers do not expect to earn forgiveness until after this date.

For this reason, it is crucial to plan for the possibility of a large tax bill.

As a borrower who doesn’t expect to earn debt relief until after 2026, I’m using a Roth IRA to plan for my tax bill. If I get a tax bill, I’ll have money saved and ready to go. If I don’t get taxed, I have extra money for retirement.

Those that don’t want to get fancy can also utilize a high-yield savings account. With interest rates currently starting around 5%, the money set aside for a potential tax bill has the opportunity to grow.

The Rules on Debt Cancellation Should Change​

Even though student loans have become a politically-charged topic, there are some areas where both parties seem to agree.

Taxing loan forgiveness is one area. Without bipartisan support, the temporary rule eliminating the tax until 2026 would never have passed.

I’d argue that parents with Parent PLUS loans have the most persuasive argument against taxing relief.

Under the Parent PLUS rules, parents are protected in the event of a tragedy. If the child for whom the loan was borrowed dies, any remaining Parent PLUS debt is forgiven.

Before the tax rule changed, these parents got hit with large tax bills. It was an outcome that was both tragic and unfair.

While it’s hard to predict the future and especially hard to predict where the political winds may blow, I’d expect the tax on loan forgiveness to eventually get permanently eliminated.

How to Calculate Your Student Loan Forgiveness Tax Bill​

Projecting a potential student loan forgiveness tax bill is a tricky business.

For starters, we don’t know whether or not this tax will exist.

If we assume the worst, we still don’t know what tax brackets will look like that far into the future. Additionally, it’s nearly impossible to project income far into the future.

In 2023, tax rates ranged from 10% to 37%. If you were taxed on $1,000 of forgiveness in 2030, and the tax rates remained the same, you would owe the IRS between $100 and $370.

The borrowers with the largest loan balances could be looking at tax bills of over $100,000!

State Taxes on Federal Loan Forgiveness​

Federal taxes are not the only issue that borrowers need to consider when considering the financial impact of loan forgiveness.

Many states follow the IRS rules on loan forgiveness. In these states, there is no tax, but it changes in 2026.

Other states don’t follow the IRS rules on determining income. Some of them currently charge borrowers a tax on the forgiven debt.

For this reason, borrowers who successfully earn student loan forgiveness can opt out. For some, the potential state tax bill is unaffordable, and opting out of the relief is the only option.

Tax Rules to Avoid the Massive Bill​

Within the IRS rules, there is a massive exception to the tax on the forgiven debt.

If the taxpayer is insolvent, meaning their total liabilities exceed their total assets, the taxpayer doesn’t have to count their forgiven debts as income.

Some states may offer a similar rule.

For planning purposes, this is another situation where planning for the worst and hoping for the best is the right approach. Don’t assume you can avoid the tax via the insolvency exception until you get the green light from an accountant.

Sherpa Tip: Because there are federal and state tax laws to consider, it is an excellent idea to talk with an accountant if you are nearing forgiveness.

A good accountant can help you understand the latest tax law developments and minimize the tax bill.

If you have a large amount of debt that is about to be forgiven, speaking with an accountant could be money very well spent.

Minimizing the IDR Forgiveness Tax Bill​

The more debt that gets forgiven, the larger the potential tax consequences.

For borrowers with large balances and lower monthly IDR payments, their balance may be growing each month.

In this circumstance, the new SAVE plan is an excellent option to keep the tax bill down. On the SAVE plan, borrowers receive a generous subsidy to keep the balance from growing.

Those who qualify for $0 per month payments have an effective interest rate of 0% on the SAVE plan.

The SAVE plan will help borrowers keep their balances from growing. Once these borrowers earn forgiveness, the amount forgiven will be smaller, and the potential tax bill will be more affordable.

All IDR borrowers should take some time to investigate the new SAVE plan, estimate potential monthly payments, and get signed up when appropriate.

The post The Guide to IDR Forgiveness and the Future Tax Bills appeared first on The Student Loan Sherpa.
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