The good news is that this daunting tax bill is often avoidable.

Unfortunately, not every borrower will be able to sidestep the student loan tax bomb. It remains a significant drawback of pursuing loan forgiveness and is an important factor for any borrower considering this option. Thus, it’s crucial to understand the potential financial impact of this tax liability and plan accordingly.

Student Loan Tax Bomb Origins

The student loan tax bomb originates from a specific tax rule that requires forgiven debt to be taxed as income in the year it was forgiven.

This rule often makes sense in various contexts. For example, if you work for Visa and Visa forgives some of your credit card debt as a bonus, it’s reasonable to tax that forgiven debt as income. This prevents companies from exploiting loopholes by issuing “loans” to employees and then “forgiving” them as a way to avoid paying taxes.

Treating forgiven student loans as taxable income follows the same logic, ensuring fairness in the tax system. Regrettably, the tax bomb creates a financial challenge for the student loan borrowers receiving the forgiveness. Student loan borrowers should, therefore, prepare themselves to overcome that hurdle.

Student Loan Forgiveness Isn’t Taxed – For Now

Currently, student loan forgiveness is a notable exception to the rule taxing forgiven debt.

Sadly, this particular exception ends on January 1, 2026 for many types of student loan forgiveness. In other words, if you reach IDR forgiveness before 2026, you are in the clear. If you are making payments on the SAVE plan until 2029, there could be a large tax bill in your future.

PSLF Special Exception: Unlike IDR forgiveness, PSLF tax-free forgiveness is permanently written into the tax code.

If you expect to earn PSLF forgiveness in 2030, there won’t be a huge tax bill waiting.

The Rules After 2026 and Planning for the Worst

Starting January 1, 2026, the temporary rules excluding most forgiven student loan debt from taxable income will expire. At that point, the student loan tax bomb will be in play again.

While 2026 may seem distant, it’s important to note that many borrowers do not expect to earn forgiveness until after this date. Therefore, it is crucial to prepare for the possibility of a large tax bill.

As a borrower who doesn’t expect to earn debt relief until after 2026, I’m using a Roth IRA to plan for my tax bill. This approach allows me to save money in a tax-advantaged account. If I end up with a tax bill, I’ll have the funds set aside and ready to go. If I get lucky and Congress passes more legislation that exempts my debt forgiveness from taxable income, I will have saved extra money for retirement.

For those looking for a simpler option, a high-yield savings account can also be a good strategy. Any money saved for a potential tax bill can earn a decent return, growing over time.

The Rules on Debt Cancellation Should Change

Student loans have indeed become a politically charged topic. Yet, there appears to be bipartisan agreement on certain aspects, such as the taxation of loan forgiveness. The temporary rule that prevents the taxation of forgiven loans until 2026 wouldn’t have passed without support from both parties.

One compelling argument against taxing forgiven debt comes from parents with Parent PLUS loans. Under the rules for these loans, if the child for whom the loan was taken out passes away, the remaining debt is forgiven. However, prior to the change in tax rules, these parents faced substantial tax bills on the forgiven amounts—an outcome that was both tragic and widely regarded as unfair.

While predicting political outcomes is inherently challenging, the bipartisan support for the temporary tax relief measure suggests a growing recognition of the unfair burden placed on individuals in already difficult situations. Given this, there’s reason to hope that Congress might eventually eliminate the tax on forgiven student loans permanently, offering significant relief to borrowers.

How to Calculate Your Student Loan Forgiveness Tax Bill

Projecting a potential student loan forgiveness tax bill is tricky business. There are a number of uncertainties that make accurate forecasting difficult.

For starters, we don’t even know if this tax will exist by the time many borrowers qualify for forgiveness. Even if we prepare for the worst-case scenario in which the tax remains in place, predicting future personal income levels and tax brackets is nearly impossible.

In 2023, tax rates ranged from 10% to 37%. To illustrate what this means, here is an example. If you received $1,000 in forgiveness in 2030, and the tax rates remained the same, this would result in adding between $100 and $370 to your tax bill. The borrowers with the largest loan balances could be looking at tax bills of over $200,000!

State Taxes on Federal Loan Forgiveness

Federal taxes aren’t the only issue that borrowers need to consider when planning for the financial impact of loan forgiveness. State taxes may also play a role in the overall financial effects of loan forgiveness.

Many states align their tax policies with the IRS regarding loan forgiveness. In these states, there is no tax — at least until the federal exemption expires in 2026. At that point, these states may tax forgiven debt unless the legislature makes further changes.

Some states have their own rules for determining taxable income and do not follow IRS guidelines for forgiven debts. Some of them currently do tax forgiven debt while other states are considering following suit. For example, in 2023, Indiana, North Carolina, and Mississippi included student loan forgiveness as taxable income. Thus, even if Congress permanently excluded this income from tax, your state could still have different ideas about its taxability.

Because of these varying state tax implications, some borrowers who qualify for student loan forgiveness may find themselves in a position where accepting the forgiveness isn’t financially beneficial. In extreme cases, the tax bill could be so high that opting out of forgiveness becomes the more viable option. Borrowers should carefully assess their individual tax situations—considering both federal and state implications—to make the most informed decision about pursuing student loan forgiveness.

Tax Rules to Avoid the Massive Bill

As previously mentioned, the general rule is that forgiven debt is taxable income unless Congress has specifically excluded it. The IRS provides some additional reasons why taxpayers can still exclude forgiven debt from taxable income. The main exclusion that might be helpful to student loan borrowers is regarding insolvency.

In essence, the rule is that the taxpayer can exclude forgiven debt to the extent that the taxpayer was insolvent immediately before the forgiveness. What this means is that if the taxpayer’s total liabilities exceeded their total assets at the time of forgiveness, the taxpayer can exclude some or all of the forgiven debt from taxable income.

Some states may offer a similar exemption. However, the rules can vary widely, and not all states align with federal rules on this matter.

For those considering this as part of their financial strategy, it’s essential to approach with caution. Planning for the worst while hoping for the best is advisable. Don’t assume you can avoid the tax via the insolvency exception until you get the green light from an accountant. This careful approach ensures that you’re fully prepared for any tax implications that may arise and can plan accordingly.

The IRS provides Low Income Tax Clinics for those who qualify.

Sherpa Tip: Because there are federal and state tax laws to consider, it is an excellent idea to talk with an accountant if you are nearing forgiveness.

A good accountant can help you understand the latest tax law developments and minimize the tax bill.

If you have a large amount of debt that is about to be forgiven, speaking with an accountant could be money very well spent.

Minimizing the IDR Forgiveness Tax Bill

The more debt that gets forgiven, the harsher the tax consequences can be.

For borrowers who have substantial balances and are making lower monthly payments under an IDR plan, their balance might actually be increasing each month if their payments don’t cover all of the accruing interest.

In this circumstance, the new SAVE plan offers an excellent option to keep down the tax bill. On the SAVE plan, borrowers receive a generous subsidy that helps prevent the loan balance from growing.

This is particularly advantageous for those who qualify for $0 per month payments. They have an effective interest rate of 0% on the SAVE plan.

By keeping the balance stable or even reducing it, the SAVE plan helps ensure that when borrowers eventually qualify for forgiveness, the total amount forgiven—and consequently, the potential tax bill—will be more manageable.

All IDR borrowers should investigate the new SAVE plan, estimate potential monthly payments, and sign up when appropriate.

The post The Guide to IDR Forgiveness and the Future Tax Bills appeared first on The Student Loan Sherpa.

Some of these programs were created to provide financial relief during the Covid-19 pandemic. Others came into existence under temporary authority from Congress or to provide a one-time fix caused by servicer errors and borrower confusion.

Problems arise when borrowers are told one thing but see rules posted that say the exact opposite.

The goal of this article is to clear up potential confusion caused by temporary fixes to federal student loan rules.

Taxes on Federal Student Loan Forgiveness

It isn’t easy to keep track of the tax rules on student loan forgiveness. Recent temporary changes only make things more confusing.

Public Service Loan Forgiveness (PSLF) is tax-free. This rule is written into the statute. If you qualify for PSLF, you won’t have to pay any tax on the forgiven debt.

If you qualify for forgiveness after 20 or 25 years under an IDR plan, the rules are less clear. The general rule was that this form of forgiveness was taxed. Borrowers often called it the student loan forgiveness tax bomb.

Fortunately for many borrowers, the tax bomb was temporarily suspended through recent legislation. If your loans are forgiven under IDR forgiveness before 2026, there will not be a tax bill. If you reach forgiveness after January 1, 2026, the current rules call for you to get taxed.

Sherpa Thought: Planning a repayment strategy when the rules are uncertain isn’t ideal. I think the tax on IDR forgiveness will eventually get permanently erased. However, as a borrower working towards IDR forgiveness, I have a backup plan to get ready for the tax.

Limited Waiver on PSLF

When borrowers first became eligible to have their loans erased via PSLF, the initial rejection rate was 99%.

Even though the numbers improved slightly, it was clear that many deserving public servants had applications rejected. Problems often centered around ineligible repayment plans and ineligible federal loans.

To fix this problem, the Department of Education created the Limited Waiver on PSLF. This allowed borrowers to correct previous PSLF mistakes and update their progress.

Sadly, the Limited Waiver program ended on October 31, 2022. Borrowers with PSLF eligibility issues now have to use the less generous Temporary Expanded PSLF. The TEPSLF program will remain active until the funding runs out.

IDR Count Update

The Department of Education will be updating each borrowers progress toward the 20-25 years required for IDR forgiveness.

All previous periods of repayment will now count as progress for IDR forgiveness. Additionally, some deferments and forbearances will also count. Borrowers with FFEL loans will need to apply to consolidate into a federal direct loan by December 31, 2023, to take advantage of this program.

Notably, this updated count will also help borrowers who are pursuing PSLF. For FFEL borrowers, the IDR count update almost functions as an extension on the limited waiver program.

IDR Consolidation and Restarting the Student Loan Forgiveness Clock

The basic rule is that if you consolidate your federal student loans, your progress towards IDR forgiveness restarts at zero. While consolidation is an important move for some borrowers, this wrinkle makes the decision to consolidate somewhat more complicated.

However, there is a temporary rule in place that will allow borrowers to consolidate without losing their progress toward IDR forgiveness. For some borrowers, consolidating now is a great way to keep previous progress and get credit for some prior deferments and forbearances.

The deadline for borrowers to take advantage of the one-time IDR count update is December 31, 2023.

It is also worth noting that some recently announced proposed student loan changes would allow borrowers to consolidate without losing progress towards forgiveness. However, at this point, nothing has been finalized.

Changes to Bankruptcy Rules

For many years, getting student loans discharged in bankruptcy was nearly impossible. Most bankruptcy attorneys wouldn’t even take the case.

Last fall, the Biden administration quietly updated the guidance for Department of Justice attorneys in bankruptcy cases. These changes make it significantly easier for borrowers to erase student debt in bankruptcy. The hope is that most bankruptcy attorneys will now be able to help student loan borrowers.

The changes do not alter any statutes or case law, so a new presidential administration could mean the borrower-friendly bankruptcy rules get erased.

Federal Student Loan Payment and Interest Freeze

The federal student loan payment and interest pause continues to this day.

Sadly, the Covid-19 relief will eventually come to an end. At that point, borrowers will have to resume making payments, and loans will resume accruing interest.

The date of the restart will depend upon when the Supreme Court rules on Biden’s one-time forgiveness plan.

$0 Per Month Student Loan Payments

Many borrowers get confused when IDR Payments result in a $0 per month payment. This “payment” counts towards the various forgiveness programs. Even though it feels like a deferment or a forbearance, it is a much better alternative.

$0 per month payments are permanent because borrowers can qualify each year until their debt is forgiven. However, it is temporary, because you have to certify your income each year. If you start earning more money, the $0 payments may come to an end.

What Student Loan Programs are Permanent?

Many borrowers fear that “permanent” programs like IDR repayment or PSLF are not actually permanent.

While it is true that Congress could theoretically end these IDR or PSLF, it isn’t a likely event. These changes would be highly unpopular and controversial. Such a bill is unlikely to get through Congress and be signed off by the President. Even if it did, borrowers have protections in the contract they signed with the government.

The student loan contract is called the Master Promissory Note. It spells out the rules for the student loan, repayment plan terms including IDR, and Public Service Loan Forgiveness.

The multiple layers of protection make recent proposals to end PSLF less threatening to borrowers.

The post Guide to Temporary Programs and Permanent Rules for Federal Student Loans appeared first on The Student Loan Sherpa.

That said, for many borrowers, student loan forgiveness still represents the best path to debt freedom.

Once you understand how student loan forgiveness works, the reality of the situation is clear. It is not too good to be true. Instead, student loan forgiveness is a challenging path that is potentially very rewarding for borrowers.

High Rejection Rates: Student Loan Forgiveness Isn’t Easy

Many borrowers mistakenly assume that after ten years of work in public service or 20 years of repayment, their loans will disappear.

The harsh reality is that many borrowers have their applications for forgiveness rejected. When the first batch of borrowers became eligible to apply for Public Service Loan Forgiveness, the rejection rate was over 99%. The real rejection rate isn’t that high, but approval is far from a certainty.

Likewise, forgiveness after 20 years of income-driven repayment is far from automatic. The National Consumer Law Center estimates that over two million borrowers have been in repayment long enough to qualify for IDR forgiveness, yet only 32 have qualified. Here again, the numbers should improve for borrowers, but assuming that you will qualify is a mistake.

The lesson with these high rejection rates is that attention to detail is critical.

Don’t Rely on Student Loan Servicer Assurances

One of the biggest obstacles for borrowers chasing forgiveness has been lousy advice from student loan servicers.

Bad information from some servicers was the subject of a Consumer Financial Protection Bureau lawsuit. I’ve personally spoken with many borrowers who were told they were on their way to forgiveness, only to learn that they were not.

Making this problem even more severe is the fact that there isn’t a remedy for most borrowers. If you rely on bad information from your servicer, you are often out of luck. Congress has tried to address this particular issue with the Temporary Expanded Public Service Loan Forgiveness program. Sadly, it only helps some PSLF borrowers who were on the wrong repayment plan.

If there is good news in this situation, it is that this issue is starting to improve. Servicers now get better training on loan forgiveness issues, and borrowers do a better job researching the rules. However, there is still plenty of room for improvement.

Borrowers can still ask their servicers for help and guidance, but they need to verify the information provided.

The Student Loan Tax Bomb

Even if you do everything right and your loans get forgiven, the “catch” is that you may have a huge tax bill from the IRS.

The IRS usually treats forgiven debt as income the year it is dismissed. There are a couple of exceptions to the basic rule for student loan forgiveness. First, Public Service Loan Forgiveness is never taxed. Second, the other forms of federal student loan forgiveness are not taxed if the forgiveness occurs before December 31st, 2025.

Borrowers that do not qualify for either expectation may have to pay a large tax bill. In the student loan community, that tax bill has come to be known as the student loan tax bomb.

Thoughts from the Sherpa: I’m optimistic that Congress will eventually remove the student loan tax bomb. However, as an IDR borrower, I’m not counting on Congress delivering. I have a plan in place to handle the tax bomb.

Federal Student Loan Cancellation from President Biden or Congress

Some borrowers are already planning on having the federal government cancel their student loans.

These borrowers are making the mistake of counting their chickens before they hatch.

While there is certainly reason for optimism about federal cancellation, it is a long way from becoming a reality. At present, one political party is 100% opposed to loan cancellation, and the other party only has some members interested. There are many legal and political hurdles in the way of student loan cancellation.

The “catch” with this form of student loan forgiveness is that it may never happen for anyone.

Still Interested in Loan Forgiveness?

The big lesson here is that student loan forgiveness is far from a certainty. However, it isn’t impossible either.

Borrowers interested in loan forgiveness should do the following:

• Review the different types of forgiveness available.
• Talk to your loan servicer to discuss your progress and the requirements.
• Borrowers chasing Public Service Loan Forgiveness should use the PSLF Help Tool and submit the necessary forms to certify their progress so far.

The post What is the “Catch” with Student Loan Forgiveness? appeared first on The Student Loan Sherpa.

Obviously, I’m not 100% certain about this prediction, but things are definitely trending in the right direction for borrowers.

I’m putting my track record of accurate student loan predictions on the line and saying that the tax bomb won’t become a reality.

Why a Huge Student Loan Tax Bill is Unlikely for ICR, IBR, PAYE, and SAVE Borrowers

During the COVID-19 pandemic, Congress passed a law containing a provision that eliminates the tax on forgiven student debt until 2026. For the borrowers who will earn Income-Driven Forgiveness in the next few years, there is nothing to predict — there will be no tax bomb.

Unfortunately, most borrowers currently on the IDR plans will not qualify for forgiveness by the December 31st, 2025, expiration. One noteworthy aspect of the recently passed provision is that it eliminates the tax from the first borrowers earning forgiveness.

Additionally, this isn’t the first time Congress eliminated a tax on student loan forgiveness or cancellation. A couple of years ago, Congress removed the harsh tax on student loans forgiven due to death or disability discharge. Like the recent legislation, the provision ends December 31st, 2025.

The message from Congress is clear: student loan borrowers who have their debt discharged should not pay tax on the forgiveness.

Supporting the Student Loan Tax Bomb Would Be Dumb Politically

Stepping back from what the rules should be or what is fair, let’s look at the politics.

Calling for a huge tax bill for someone who spent at least 20 years making student loan payments looks bad. Democrats have strongly advocated for student loan cancellation and further help for borrowers. Republicans have built their brand on tax opposition.

When this issue comes up for debate again, eliminating the tax should get bipartisan support. Democrats need to stick up for student loan borrowers to get elected. Republicans need to oppose tax increases to get elected. Preventing a tax increase on student loan borrowers should be an easy sale.

Even though there is a huge debate about student loan cancellation, there hasn’t been a debate on these tax issues. Most advocates and experts argue that the tax bomb is a bad policy, and there has been little opposition.

Taxing Forgiveness is Bad Policy in this Case

The general rule of the IRS on taxing forgiven debt makes sense. Suppose my employer loans me $1,000. When you borrow money, there is no tax paid by the lender or the borrower. Instead of giving me a raise or a bonus, my employer cancels my debt. You can see how easy it would be to use a strategy like this to avoid taxes if there wasn’t a rule taxing canceled debt.

Applying this rule to student loan forgiveness and cancellation doesn’t make sense. If I qualify for IDR forgiveness, it is because I’ve been on an income-driven repayment plan for 20 years. I’ve made 20 years’ worth of payments, and I’ve paid interest on the debt. Presumably, I’ve been on this plan because I can’t afford to pay off my student loans under the standard 10-year plan. In this situation, student debt has been a financial hardship, and I’ve gone to great lengths to do what I can to make payments.

A huge tax bill in that situation is wrong. For starters, many borrowers who face the tax bomb probably can’t afford the bill. Secondly, it isn’t forgiving the debt if you are just turning it into an IRS bill.

My Big Hesitation in Predicting the Elimination of the Student Loan Tax Bomb

For years, when I discussed student loan issues, I only made suggestions based upon the current status of the law. This approach was safe and it was easier.

However, my inbox was full of emails from readers asking about what might happen and how to plan for various possibilities. It is smart to plan for various contingencies, and to the extent I can offer insight on a topic, I try to do so.

In the case of the student loan tax bomb, I still think borrowers should prepare as though it will happen. As a student loan borrower myself, I’m making preparations for a huge tax bill. My plan incorporates the fact that I think I probably won’t face this bill. Even though I don’t expect the tax to happen, I’m not going to bet on Congress doing the right thing or the smart thing. I have a backup plan in place, and I think every borrower should do the same.

Please don’t assume Congress won’t tax forgiveness. Get ready for a tax bill, and when Congress eliminates the tax, enjoy the fruits of your labor.

The post Why This Expert Thinks the Student Loan Tax Bomb Probably Won’t Happen appeared first on The Student Loan Sherpa.

Because a huge tax bill at forgiveness is only a possibility, I’ve devised a plan that will help me prepare for this possibility and maximize my options if it doesn’t become a reality.

Why Plan for a Huge Student Loan Tax Bill?

The Public Service Loan Forgiveness borrowers are the lucky ones. Not only do they get their student loans forgiven after just ten years, but the forgiveness is tax-free.

IDR borrowers are not as lucky. As the rules stand right now, many will have to pay taxes on the debt forgiven under IBR, ICR, PAYE, or SAVE. This is because the IRS’s general rule is to treat forgiven debt as income in the year it is forgiven. This rule has given rise to the term student loan tax bomb.

The recent stimulus package had a small student loan provision that could make a massive difference for some IDR borrowers. Loans that are forgiven between now and 2026 will not be taxed. Unfortunately, I won’t be reaching forgiveness that soon, so as the law stands, I still have to plan for a tax bill.

I’m optimistic this tax bill may not ever happen, but I don’t trust Congress enough to assume that I won’t have to worry about it.

My Tax-Bomb Plan is a Roth IRA

Right now, I’m saving money for an uncertain future.

I may need money for a large tax bill. Ideally, that bill never comes. Hopefully, I can set that money aside now and save it for retirement. In this scenario, a Roth IRA makes the most sense.

I use a Roth IRA for three reasons:

1. It is an excellent retirement account.
2. I can withdraw my contributions at any time without taxes or penalties, so if the tax bill comes, I have funds available.
3. If I have some other immediate emergency, I can dip into this savings.

The unique and flexible rules of a Roth IRA make it the ideal type of account for this particular situation.

Roth IRA Flexibility vs. a Bank Savings Account

The top two options for my tax bomb plan were a standard savings account and the Roth IRA.

I was able to quickly eliminate options like a 401(k) or a Traditional IRA. Of the many different retirement accounts, the Roth IRA stood out as the best choice. Most other retirement plans impose a penalty for withdrawals before reaching retirement age. Because I may need the money in about ten years, these plans will not work.

Thus, the decision came down to Roth vs. a savings account.

The significant benefit of a savings account is that it is easy. Every bank offers one, and I can take the money out whenever I like. However, I see two major downsides. First, with that ease comes temptation. It would be easy to pull some money out of that account to make a purchase that isn’t necessary. Additionally, there are no tax benefits, and the interest rates on a savings account are terrible these days.

Having a Roth IRA means major tax advantages. The money inside a Roth account grows tax-free. If it ends up being a retirement account, I can use those funds without facing any tax considerations.

The Roth downside is that only contributions can be withdrawn penalty-free. In other words, if I put $10,000 into a Roth IRA and the balance grows to $10,800, I only have my original $10,000 contribution available for my student loan tax bill. The remaining $800 will have to sit in the Roth account until I hit retirement age… or I will have to pay a penalty on the $800 that got pulled out early.

However, the biggest advantage of the Roth IRA is that I can invest the money to grow my savings. I tend to invest conservatively because I may need the money in about ten years. This route is riskier than a standard savings account, but it has a higher upside. If we ever get more clarity on student loan taxes, I can also change my investment strategy to a longer outlook based on my retirement.

A Final Advantage: Funds in an Emergency

I’m a huge supporter of having an emergency fund. This especially holds true for student loan borrowers. If you depend upon high-interest credit cards to weather a financial hardship, it will be costly.

Many argue that a Roth IRA is an excellent supplemental emergency fund. Ideally, that money gets used in retirement. However, if you face desperate circumstances, the Roth account is a huge asset.

I hope to use my Roth IRA for my retirement. However, I’m ready to use my Roth IRA to pay a large student loan tax bill. If necessary, I have my Roth IRA for a major financial emergency.

I suspect many federal borrowers working towards IDR forgiveness will find a Roth IRA to be an excellent resource.

The post My Plan for the Student Loan Tax Bomb appeared first on The Student Loan Sherpa.