The Downside of Student Loan Forgiveness: A Huge Tax Bill
Student borrowers that get loan forgiveness after using an income-driven repayment plan may be subject to a large tax bill.
Students looking for student loan debt relief might also find themselves with an unexpected tax bill. These one-time tax bills are a component of the Education Department’s income-driven repayment plans.
Created in 2007, one version of the plan enables borrowers to establish monthly federal student loan payments of 10 percent from their discretionary income; over time, these balances can grow as monthly payments don’t cover accruing interest, leaving the principal balance untouched.
This happens as completion rates for the monthly payments are 20 or 25 years for private sector workers; when they are finished, outstanding balances are forgiven. But this is when the IRS comes in and spoils the celebration: federal tax rules state that written-off debt is considered a portion of the borrower’s income for that year and it needs to be taxed. Note that this specifically applies to debt forgiven under an IDR plan, not under a Public Service Loan Forgiveness plan.
Tax bill numbers are growing as 7 million borrowers owe $389 billion in income-driven repayments, according to Education Department data. The first wave of borrowers will probably have their debt purged in 2027 but before then with rising plan enrollments, a crisis is looming, potentially affecting borrowers and the government as individuals won’t be prepared for these one-time tax bills, The Wall Street Journal reported.
Just how large is the figure? According to the Government Accountability Office, in 2016, it expected $108 billion in student debt loan forgiveness by the government for that year. This number is growing, so figures are likely understated. In any case, students who get their student loans forgiven under this plan should prepare for a big tax bill.
IRS Collection Methods
The IRS employs numerous methods to collect unpaid taxes. That can include placing liens on borrowers’ homes as well as garnishing Social Security checks and wages on retirees when they fail to pay taxes.
For borrowers unable to pay their tax bills, they may either work out deals with the IRS or the agency may write off taxable amounts, according to experts. But borrowers are not guaranteed to be able to work out a deal.
Graduate school or prestigious private institutions graduates tend to have higher incomes and access to financial advisers to learn about plan benefits and how to cut tax debt. Low-income borrowers who don’t have these resources might be less prepared financially for tax bills, The WSJ reported.
But things could change. Justin Draeger, head of the National Association of Student Financial Aid Administrators, noted to The WSJ that when Congress initially passed the IDR program, tax bills were probably an afterthought. He thinks once tax bills begin arriving en masse, Congress will face pressure to end the tax, which may possibly add billions of dollars in taxpayer costs for the student loan program.
There are other ways borrowers can lower their monthly payment if they anticipate having trouble repaying. Rolling federal student loans into a direct consolidation loan and extending the term can lower the payment; likewise, refinancing student loans through a private lender might reduce the monthly payment if they can get a lower interest rate or a longer repayment term.