Student Loan Forgiveness and Taxes

February 15, 2018
By: Mason Gallik

To help increase student loan affordability, the government has several income-driven repayment programs. These are meant to keep student loans affordable for borrowers who are struggling to repay their loans. PAYE and REPAYE are two of the most popular. They provide a way for loans to be forgiven after 20 years if you have loans from undergraduate studies or 25 years if you have some graduate loans. Both these plans allot your monthly payment to become 10% of discretionary income. More information on these repayment plans can be found here because the purpose of this article is to discuss the tax implications of loan forgiveness.

According to the IRS, loan forgiveness counts as income. This can have severe implications for borrowers in income-driven repayment plans. While you may have debt that is “forgiven” after you make 20-25 years of payments, Uncle Sam still wants you to pay up. Any debt forgiven is taxed at your marginal tax rates.

For example, Adelina went into the REPAYE program and paid 10% of her income on a large amount of graduate school loans for 25 years. At age 50, she makes her final payment and gets $30,000 in loans forgiven. At the time, Adelina is single and making $40,000 per year. This means her marginal tax rate is 22%. Adelina will get $30,000 in loans “forgiven,” but will owe the government $6,600 in federal income taxes.

$30,000 x 0.22 = $6,600

According to the IRS, she made $70,000 this year as opposed to $40,000 since she had $30,000 in loan forgiveness. Unfortunately, she will be taxed on that total amount. Not only was she paying 10% of her discretionary income towards these loans, but she now owes the IRS an additional $6,600 or 16.5% of her total income! This can be crippling to borrowers who are unaware because the IRS expects that to be paid all at once.

PAYE, REPAYE, IBR, and ICR all count loan forgiveness as taxable income. Unfortunately, the only income-driven plan that your debt would truly be forgiven in is PSLF. Loans forgiven under PSLF are not taxable. However, it is important to be aware that loan forgiveness can leave you with a large tax bill if you are in other plans. You do not want to be caught with an unexpected thousand dollar tax bill!