Student loan forgiveness can eliminate your loan balance, but it can also trigger a tax bill, known as a “tax bomb,” because some forgiven debt is taxable. Learn how to prepare for a student loan forgiveness tax bomb.
Will I be taxed if I receive student loan forgiveness?
If your loan balance is forgiven you may be obligated to pay taxes on the forgiven amount. Your forgiven loans may be considered "income," which would put them into the taxable category. This can affect borrowers on income-driven repayment plans who've made reduced student loan payments for years.
When should you plan for a student loan tax bomb?
If you receive forgiveness, you may face a large tax bill that’s due when you pay your taxes for that year. The best way to prepare for this is to estimate your projected student loan forgiveness and set aside money before the tax bomb hits.
» Get help: What to do if you can't pay your taxes
What types of forgiveness are not taxable?
Borrowers on income-driven repayment plans may experience a student loan forgiveness tax bomb. IDR plans can last up to 25 years, and if you don’t pay off your loan during that term, the remaining balance is forgiven — but taxed as income. Some states also tax student loan forgiveness (see below).
If you receive forgiveness under a different federal student loan program, it will likely be tax-exempt. You won’t face a tax bomb in the following situations:
You work for a qualifying employer. Amounts forgiven through Public Service Loan Forgiveness and Teacher Loan Forgiveness, as well as the National Health Service Corps Loan Repayment Program and similar repayment programs, aren’t taxable.
You die or become totally and permanently disabled. This applies to you or the student benefitting from the loan, in the case of parent PLUS loans. In instances of a death discharge, your estate won't be taxed.
You qualify for a different federal student loan discharge. Loans can be discharged tax-free in instances in which your school defrauded you or closed while you were enrolled, for example.
Your Perkins loans are canceled. If you taught or performed other employment or volunteer service that qualified for Perkins loan forgiveness, you won’t be taxed on this amount.
If you have a forgiven student loan, you should receive a cancellation of debt form, known as Form 1099-C, for your taxes.
How much will you pay?
The size of a student loan tax bill depends on the amount forgiven as well as your finances overall. Since loan forgiveness can be counted as income, the forgiven student loan could push you into a higher tax bracket — further increasing your tax burden.
For example, if your taxable income was $100,000 and you claimed the standard deduction, you would owe over $13,000 in taxes.
But let’s say you also had $50,000 in student loans forgiven. That additional "income" would push your federal return into a higher tax bracket, increasing your tax bill to over $24,700 — a $11,700 difference.
Some states tax student loan forgiveness
Borrowers in Arkansas, Indiana, Mississippi, North Carolina and Wisconsin must pay state income taxes on some forgiven federal student loans. Be sure to check your individual state's laws to know how forgiveness would be treated.
How to prepare for a forgiveness tax bomb
If you don’t think you’ll fully repay your loan over the long term, use that time to prepare for the fallout of a potential tax bomb.
Estimate your bill. Use the Loan Simulator at StudentAid.gov to estimate your loan forgiveness amount and timeline. Tax brackets can change over time, but looking at your earning potential with data from the Bureau of Labor Statistics can help you at least estimate how much you’ll eventually owe.
Choose the right plan. When deciding between income-driven plans, many factors matter, like your degree and marital status.
Prioritize saving. Instead of paying extra toward your loan, invest money with your forgiveness tax bomb in mind. For example, set aside $50 a month for your eventual bill. That small amount may not make a dent in your loans, but after 25 years with just 2% compound interest, you’ll have saved nearly $19,600 — hopefully enough for your tax bill. A savings goal calculator can help you determine how much to put aside.
» Earn interest on your tax bomb savings with a high-yield savings account
What if you can’t afford your tax bill?
Payment plans are available if you can’t afford your tax bill. IRS payment plans charge fees and interest, and rates can change every three months.
In some cases, if the IRS regards you as insolvent — or having liabilities that exceed your assets — you may be able to exclude some or all of the forgiven amount from your income. Talk to a tax professional after your loan is forgiven to understand whether this is an option for you.
Are there tax breaks for student loan borrowers?
If you’re repaying student loans, see if you qualify for the student loan interest deduction. This deduction decreases the amount of taxable income you have, potentially lessening your tax bill. Additional education tax credits are available if you paid for eligible education costs in the past year.
What are employer student loan benefits?
Some employers offer a benefit to help you pay for student loans. While forgivable loan programs for lawyers, educators or other professionals may be tax-exempt, amounts your employer offers as a student loan repayment benefit may be taxable income. Read the paperwork of any benefit plan carefully to know what your tax liability may be.
