Will Your State Tax Your Canceled Student Debt?

Several states are poised to collect income taxes on student loan forgiveness — a move that could leave some borrowers owing as much as $1,000 during tax season.

Individuals in Indiana, Mississippi and North Carolina will almost certainly pay state income taxes on their forgiven federal student loans, according to representatives of those states' revenue departments and analysis from the Tax Foundation, a tax policy think tank based in Washington, D.C.

Meanwhile, a handful of other states are tentatively planning to tax forgiven student loan debt unless their legislatures take measures to prevent it.

President Joe Biden's executive order on Aug. 24, 2022 could erase all remaining federal student loan debt for as many as 20 million borrowers, according to the White House, and reduce the debts of millions more. In general, borrowers are eligible for up to $20,000 in debt cancellation if they earn less than $125,000 and file taxes as an individual or are married, file jointly and earn less than $250,000.

While the federal government explicitly stated in the March 2021 American Rescue Plan Act that it won't collect taxes on student debt forgiven through Dec. 31, 2025, not all states are held to the same pledge. Here's what we know about the rest.

Arkansas

Forgiven student debts are expected to be taxed as income in Arkansas. However, that'll change if the state's legislature takes action, said Scott Hardin, an Arkansas Department of Finance and Administration spokesperson, in an email. Hardin noted that the state's legislature took action to exempt PPP loans from taxation and froze taxation on unemployment payments for two years. It is unclear whether the Arkansas Legislature anticipates any such measures passing for student debt forgiveness.

Arkansas has a graduated income tax rate that ranges from 2% to 4.9% depending on annual income, according to the state's Economic Development Commission. Individuals making less than $5,000 are exempt from state income tax.

California

Forgiven student debts will be taxed as income in California, said Andrew LePage, a spokesperson for California's Franchise Tax Board, in an email. That's because student loan forgiveness isn't occurring under Section 1098-E of the federal Education Code, LePage said, and therefore, it doesn't meet an exclusion requirement in the state's tax code. Section 1098-E, titled "Income-Based Repayment," is in Chapter 28 of the federal Education Code, which pertains to higher education and student financial aid, according to the U.S. Government Publishing Office.

That could change, though. In December 2022, a bill was introduced in the California Legislature that would exclude forgiven student debts from being subject to income taxation in the state. It is unclear whether the bill will come up for a vote in the upcoming 2023-2024 legislative session.

Indiana

Indiana residents will be taxed on forgiven student loan debts, said Natalie Rodriguez, assistant director of communications at Indiana's Department of Revenue, in an email.

The state's income tax rate is 3.23%, so individuals could pay up to $323 in taxes for $10,000 in student loan forgiveness or $646 for up to $20,000 in student loan forgiveness, Rodriguez said. Indiana residents will also have to pay additional county taxes on the forgiven debts, Rodriguez said.

Minnesota

In Minnesota, forgiven student debts will not be taxed as income, said Ryan Brown, a spokesperson for Minnesota's Department of Revenue, in an email. If an individual’s forgiven student loans qualify for federal tax exclusion, they qualify for state tax exclusion in Minnesota, Brown said.

Mississippi

Mississippi is expected to tax forgiven student loan debt as income, according to the Tax Foundation. Mississippi's Department of Revenue could not be reached for comment by NerdWallet.

Mississippi charges a 5% income tax on all annual income over $10,000, according to the Tax Foundation.

North Carolina

Forgiven student loan debts are expected to be taxed as income in North Carolina, said Thomas Beam, public affairs manager at North Carolina's Department of Revenue, in an email. But the rate at which individuals will be taxed remains unclear.

The state's individual income tax is currently 4.99%, but that figure changes to 4.75% in 2023 and gradually decreases until 2026, when the rate will stand at 3.99%, per the state's Department of Revenue.

Wisconsin

As it stands, forgiven student loan debts will be taxed as income in Wisconsin. Changing that would require specific action from the state legislature, said Patty Mayers, communications director at Wisconsin's Department of Revenue, in an email. That action hasn't been taken yet, Mayers said, but it could still take place in 2023 when the state legislature is back in session.

"We have addressed this discrepancy with federal law in our department's biennial budget request, in an effort to ensure Wisconsin taxpayers don't face penalties and increased taxes for having their loans forgiven," Mayers said.

Wisconsin's income tax rate ranges from 3.54% to 7.65%, depending on annual income and whether you're married or single, according to the state's Department of Revenue.

How to prepare if you're affected

Whether those taxes are owed during the 2022 tax season (in early 2023) or the 2023 tax season will depend on a few factors, including when an individual completes the U.S. Department of Education's debt cancellation application. The form is expected to become available in October and close in December 2023, per the Department of Education website.

If you live in a state that might tax your forgiven student loans, consider using an online tax calculator to get an idea of how much you'll need to save. In many cases, your state's Department of Revenue website or its franchise tax board website will have such a calculator.

You can also consider using a budget app to automatically siphon off what you'll need to set aside from each paycheck.