Student loan forgiveness is going to be tax-free.
It’s a new provision included in the $1.9 trillion stimulus package that President Biden signed into law Thursday — and a big deal for federal student loan borrowers because, currently, any student loan debt canceled by the government is treated as income and can be taxed.
Depending on how much debt can be forgiven and what tax bracket a borrower falls under, it used to mean a hefty tax bill from the Internal Revenue Service.
Borrowers in income-driven repayment plans will be affected most by the change. Of 45 million student loan borrowers in the U.S., a third are enrolled in income-driven repayment plans.
Think twice before paying your federal student loans in 2021. The freeze on federal loan payments has been extended through October, so Farnoosh Torabi, host of the podcast “So Money” and contributing editor at NextAdvisor, suggests putting your money to better use this year. Start building an emergency fund or pay down high-interest credit card debt instead.
These types of repayment plans cap borrowers’ monthly bills at a percentage of their discretionary income, and cancel any of their remaining debt after 20 or 25 years. If a borrower is on an income-driven repayment plan, it’s likely because they cannot afford to pay more toward their student loans, says Taylor.
Under current law, if a borrower falls into the 22% tax bracket and has $100,000 in student loan forgiven, they may owe $22,000 to the IRS. The new provision would mean that they do not have to pay that tax.
“We call it the tax bomb,” says Taylor. “It’s not unusual for borrowers to have $100,000, $250,000, $50,000 forgiven at the end of an income-driven repayment plan,” she says. “I’m hopeful that the semi-permanent legislation will lead to permanent legislation.”
But this new provision is temporary. It would last through the beginning of 2026, but could be extended or become permanent, says Taylor. That means borrowers on income-driven repayment plans who finish their loan term between now and Jan. 1, 2026 won’t have to pay taxes on any outstanding amount that’s forgiven.
Some experts say student loan tax relief could be the first step towards a wider cancellation of student debt. Biden has repeatedly said that he supports forgiving $10,000 in student loans, but some members of his party and advocates want to go further and cancel $50,000 per borrower.
“It’s exciting to see Biden supportive of $10,000 of forgiveness for all federal borrowers, but there are a lot of issues that need to be resolved around student loan debt,” says Taylor.
Opponents of student loan forgiveness say it would be a big, misdirected wealth transfer and fail to stimulate the economy. Others say it would be unfair to past borrowers who’ve already paid off their loans, and it promotes short-term thinking that doesn’t address the underlying issue: the cost of higher education.
“Loan forgiveness can be a good policy if it’s well-targeted to people who are struggling to repay their loans,” says Mark Kantrowitz, a higher-education expert. “He might get congressional support on the $10,000 in loan forgiveness because in part it’s a compromise. It’s not, ‘let’s forgive everybody’s student loans, even those who are capable of repaying their student loans.’”
However, supporters of student loan forgiveness say that student loan borrowers have been in crisis for a long time, and it would create financial freedom for millions of borrowers. That is especially important, they say, during the COVID-19 pandemic, when many people are struggling financially and unemployment is a record high. They also point out that it’s people of color who suffer the most from the student loan crisis; data from Brookings Institute shows that Black college graduates owe $7,400 more on average than their white peers.
If a new law does cancel $10,000 in student debt per borrower, in addition to forgiven debt not being taxable, the average borrower will save $13,400 in interest, according to an estimate by Taylor.
“Prior to COVID-19, there has been very little progress in quickly introducing measures that provide borrowers with relief,” says Taylor. “I’m encouraged to see the traction.”
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