Biden Proposes Making Student Loan Forgiveness Tax-Free Permanently

On March 28, 2022, President Biden proposed making student loan forgiveness tax-free, permanently, in his fiscal 2023 budget. This proposed change primarily only affects borrowers pursuing forgiveness under 20- and 25-year income-driven repayment plans (IDR).

Public Service Loan Forgiveness (PSLF) has been tax-free since its creation in 2007 due to statute. Death and disability discharge became tax-free under the Trump tax cuts as of 2018.

Under the American Rescue Plan (ARP), all forms of student loan forgiveness are tax-free until the end of 2025. Tax-free death and disability discharge have a similar expiration date.

Although you might be tempted to get excited as a borrower, keep it mind this is only a proposal.

Why does tax-free student loan forgiveness expire?

In 2017, a veteran with a brain injury received a large amount of forgiveness due to disability. However, he received a five-figure tax bill to go along with it.

The outcry is one reason Congress eliminated taxes on death and disability discharges, which was considered taxable income under IRS law.

However, they allowed this tax-free treatment to expire in 2025. Why?

Because this tax change happened as part of the Tax Cuts and Jobs Act, which needed to be passed through budget reconciliation to avoid the filibuster.

In 2021, Democrats made all student loan forgiveness including “tax bombs” due to IDR forgiveness tax-free through the end of 2025.

Why did they allow that to expire?

Because they passed the American Rescue Plan through budget reconciliation as well.

How Biden could make IDR forgiveness tax-free

Assuming Democrats retain control of Congress and the White House for the next 20 years, student loan forgiveness will be permanently tax-free, because they can just continue passing budget reconciliation bills to avoid the filibuster thereby extending what they've already done.

However, if one of the chambers of Congress went to Republican control or the White House changed parties, then there is no guarantee that the tax-free treatment of student loan forgiveness would be renewed.

To make tax-free forgiveness permanent for borrowers on IDR plans, President Biden would need bipartisan support. Otherwise, he would need to continuously place an expiration date on this tax relief due to the rules of the Senate constraining this policy objective.

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The administration's genius budget trick for tax-free IDR forgiveness

Although some borrowers have used an income-driven repayment plan since the '90s, IDR plans did not become popular until the passage of Income-Based Repayment (IBR) in 2007.

Most borrowers were not able to sign up for IBR until 2009. Since IBR forgiveness happens after 25 years, the first moment we would see any forgiveness would be 2034.

For Pay As You Earn (PAYE), borrowers only need to pay for 20 years. The first large group of borrowers signed up for PAYE in 2013, which means they would be eligible for forgiveness in 2033.

But current budgetary rules require a 10-year estimate of the cost of proposed changes. That means you could propose eliminating the tax bomb on student loan forgiveness permanently while making the cost appear to be far lower than it is.

White House cost estimate of tax-free IDR forgiveness hides majority of cost

If your goal is to eliminate taxes on income-driven repayment for everyone, the smartest time to propose a change is when 10-year budget forecasts show almost no cost, making it seem like a no-brainer. That appears to be exactly what the White House is doing.

Here are their estimates of the cost of tax-free forgiveness per year in millions. The negative sign indicates a cost:

2022	$0
2023	$0
2024	$0
2025	$0
2026	-$2
2027	-$17
2028	-$41
2029	-$266
2030	-$292
2031	-$320
2032	-$351

Their total 10-year cost projection is $1.289 Billion. That’s a tiny number compared to the size of the federal budget.

However, it’s small because almost no cost would occur before substantial amounts of debt would be forgiven, which does not happen until 2033 at the earliest due to IDR program design.

How the cost of tax-free forgiveness becomes exponential after 2033

The adoption of IDR plans by borrowers has exploded in recent years. This is the total number of borrowers using an income driven plan on their federal loans, according to the Deptment of Education:

• 2013:  1.58 million borrowers
• 2017:  6.49 million borrowers
• 2021:  8.39 million borrowers

Here’s the amount of Direct Loans on IDR plans by year:

• 2013: $72.3 Billion
• 2017: $352.5 Billion
• 2021: $521.6 Billion

What’s more, only 40,000 of the more than 1.5 million borrowers utilized PAYE in 2013, which means most of the cost of tax-free IDR forgiveness will not be realized until the late 2030s, well beyond any formal budgetary forecasting requirements utilized by CBO and OMB that I’m aware of.

Most of the debt that existed in 2013 will be eligible for forgiveness by the mid-2030s. If you take a 40% tax rate multiplied by some share of the $72.3 billion, the cost of forgiving the debt would be in the tens of billions per year. That’s 100-times or greater than the budget cost as presented by the President.

Of course, the White House’s projections are likely reasonable. They’re just highly misleading given the cost is so heavily weighted in the years immediately following when their projection ends.

That said, it's a genius strategy to try to get a change passed before the cost becomes substantial and opposition builds. It also shows the commitment the White House has for further student loan relief, even though that might not include a large amount of broad-based cancellation.

What the Biden tax-free IDR forgiveness proposal means

A president’s budget is their wish list. Congress ultimately determines what happens. With constraints faced by budget reconciliation, it is unlikely in the near term that IDR tax-free forgiveness will happen permanently.

That said, once a precedent gets established, it usually sticks. That is why for the past two years that IDR borrowers faced the tax bomb, our student loan consulting service has assumed that the tax will not exist, while preparing for it anyway, just in case.

A few years ago, I had the opportunity to ask a Republican Congressperson about the student loan tax bomb. He said he was aware of it, but that they did not have agreement as to what to do about it.

Why permanent loan forgiveness tax relief hasn’t happened yet

My theory is that the President wants more borrowers to receive student loan relief and to sign up for IDR plans. Also, Republicans want to reduce the role of the government in student loans, seeking to use IDR taxation as a bargaining chip in a future Higher Education Act Reauthorization, which has not been completed for several years.

Theoretically, many Republicans would support eliminating taxes on student loan forgiveness. However, I suspect under the current polarized political environment, any major, permanent change is unlikely to be in the cards.

What the President’s proposal signifies is IDR forgiveness's long-term trend of making the program more and more generous, in general, and we suspect that student loan forgiveness will indeed be tax-free long term.

If you plan for either possibility, you will have a strong financial future either way.