The American Rescue Plan Act of 2021 made student loan forgiveness tax-free at the federal level through the end of 2025.
President Joe Biden wants to extend that policy indefinitely.
While the president continues to try to deliver on a sweeping federal student loan forgiveness plan, tucked into his 2025 fiscal-year budget is a provision that would shield forgiven education debt from federal taxes permanently.
Consumer advocates are in support of such a policy.
“Unfortunately, borrowers often experience significant stress as they worry about the tax bill that could come once their loan balance is forgiven,” said Betsy Mayotte, president of The Institute of Student Loan Advisors, a nonprofit.
More from Personal Finance:
Why gas is so expensive in California
Credit card users face ‘consequences’ from falling behind
After Biden praises progress on inflation, economists weigh in
Student loan forgiveness first became tax-free at the federal level in March 2021 due to a provision included in the $1.9 trillion federal Covid-19 stimulus package that Biden signed into law. That policy is set to expire Dec. 31, 2025.
How student loan forgiveness used to be taxed
Before that Covid-era change, any student loan debt canceled by the government was considered taxable and levied at the borrower’s normal income tax rate.
The federal tax bill could be hefty.
According to a rough estimate by higher education expert Mark Kantrowitz, under previous tax rules, a borrower with a remaining balance of $10,000 after 20 or 25 years of payments could have to write the IRS a check for $1,200, assuming they’re single and have an income less than $35,000. Yet, depending on a borrowers’ circumstances, their federal tax bill could be as high as $15,400, Kantrowitz said.
Borrowers can also owe state taxes on the forgiven debt.
‘Replacing education debt with tax debt’
Many student loan borrowers who get forgiveness aren’t able to afford a tax bill, Kantrowitz said.
“These borrowers have had low income for decades and are unlikely to have any assets,” he said. “The tax liability might be as much as half of their annual income, or more, on top of their current tax liability.”
If borrowers sign up for a payment plan with the IRS, they’re merely “replacing education debt with tax debt,” Kantrowitz said.
The millions of borrowers enrolled in income-driven repayment plans would be most affected by ending taxation of forgivable education debt. These plans, which cap a borrowers’ monthly bill at a share of their discretionary income, lead to debt erasure after 10 to 25 years of payments. There are currently four different plans, each with different rules.
Other student debt forgiveness plans, including a popular one for public servants and another that cancels the debt for those with serious disabilities, are already nontaxable.
The tax rules around forgivable student debt could become especially important in the coming months as the Biden administration rolls out its revised student loan forgiveness plan, which has become known as Biden’s “Plan B.”
The Supreme Court struck down the administration’s first attempt to forgive student debt in June.
Regardless of the federal policy, it’s possible a borrower could still face state taxes on their forgiven education loans.