If you’re expecting debt cancellation from the latest round of student loan forgiveness, there’s good news: It won’t trigger a federal tax bill.
The Biden administration on Friday announced a plan to wipe away $39 billion in student debt for 804,000 borrowers in the coming weeks. The forgiveness comes from fixes to so-called income-driven repayment plans, which cancel remaining student debt after 20 or 25 years of payments, depending on when they borrowed, and their loan and plan type. The fix moved eligible borrowers closer to 20 or 25 years of payments.
Student loan forgiveness is federally tax-free through 2025 because of a provision from the American Rescue Plan of 2021, Biden’s $1.9 trillion Covid-19 stimulus package.
“This includes amounts forgiven under income-driven repayment plans, which previously posed the challenge of being hit with a tax bomb at the end of the payment term,” said Ethan Miller, a certified financial planner and founder of Planning for Progress in the Washington, D.C., area who specializes in student loans.
However, the American Rescue Plan provision only covers federal taxes, and you could still see a state tax bill for your forgiven balance, depending on where you live. “It’s important to understand what your taxation might be and when you would need to pay it,” Miller said.
While the Tax Foundation estimated that seven states could tax student loan forgiveness in August 2022, it’s still possible to see legislative changes. “No one wants to be the state that’s taxing loan forgiveness,” Miller added.
Taxation of future loan forgiveness
Whether you qualify for the latest round of student loan forgiveness or anticipate benefitting from future cancellation, it’s always important to plan for taxes, said Becca Craig, a Kansas City, Missouri-based CFP at Buckingham Strategic Wealth, who also specializes in student loan planning.
While public service loan forgiveness has always been tax-free, the current taxation for income-driven repayment plans is only temporary.
“Under normal circumstances, anything forgiven is taxable, unless it’s specifically excluded,” said Lee Reams Sr., an enrolled agent and founder of TaxBuzz.
If you’re expecting future forgiveness through an income-driven repayment plan after 2025, it’s possible you can still minimize future tax liability by switching plans, Craig said.
“I would highly suggest that anyone within the 20- to 25-year [payment] realm to reach out for professional advice,” she said. “It’s a good chunk of change and could save you thousands of tax dollars.”
However, there’s also a chance that the provision for tax-free student forgiveness could be extended, according to Reams.