As you may be aware, total outstanding student loan debt in the U.S. has reportedly ballooned to over $1.4 trillion, and as more and more students face the serious problem of rising debt, many are counting on loan forgiveness programs. But student borrowers, as well as parents with Parent PLUS loans, need to be aware that a huge student loan forgiveness tax bill is the downside of student loan forgiveness.
Loan Forgiveness Basics
Your lender expects you to repay your loans even if you don’t complete your education, can’t find a job related to your program of study, or are unhappy with the education you paid for with your loan. This is true even if you were a minor (under the age of 18) when you signed your promissory note or received the loan.
However, certain circumstances might lead to your loans being forgiven, canceled, or discharged. The U.S. Department of Education explains how these terms are used:
- “Loan cancellation” and “loan forgiveness” generally refer to the cancellation of a borrower’s obligation to repay some or all of the remaining amount owed on a loan if the borrower works full-time for a specified period of time in certain occupations or for certain types of employers.
- “Loan cancellation” usually applies to the various Perkins Loan Program cancellation benefits.
- “Loan forgiveness” usually applies to the Direct Loan and Federal Family Education Loan (FFEL) Teacher Loan Forgiveness Program or the Direct Loan Public Service Loan Forgiveness (PSLF) Program. Borrowers are not required to pay income tax on loan amounts that are canceled or forgiven based on qualifying employment.
- “Loan discharge” generally refers to the cancellation of a borrower’s obligation to repay some or all the remaining amount owed on a loan due to circumstances such as school closure, a school’s false certification of a borrower’s eligibility to receive a loan, a school’s failure to pay a required loan refund, or the borrower’s death, total and permanent disability, or bankruptcy. In some cases, a discharge may also entitle a borrower to receive a refund of payments previously made on a loan. Depending on the type of discharge, the amount of a loan that is discharged may be treated as taxable income.
The following table illustrates the various types of loan forgiveness, cancellation, and discharge, and how they apply to the various types of loans:
*FFEL Program loans and Perkins Loans may become eligible for Public Service Loan Forgiveness if they are consolidated into the Direct Loan Program.
In addition, you may be eligible for discharge of your federal student loans based on “borrower defense to repayment” if you took out the loans to attend a school that misled you, or engaged in other misconduct in violation of certain state laws, and if the school’s act or omission directly related to your federal student loans or to the educational services that you paid for with the loans.
As with loans made to students, a parent PLUS loan follows the same general guidelines: they can be discharged if you (the borrower) die, become totally and permanently disabled, or if your loan is discharged in bankruptcy. Your parent PLUS loan may also be discharged if the child for whom you borrowed dies.
The Downside: A Huge Student Loan Forgiveness Tax Bill
The result of having all or part of your loan forgiven, canceled, or discharged may seem like a godsend. However, it also means that you will likely be required to report this amount on your tax return as income. Also, bear in mind that tax consequences apply to all loans forgiven under Pay As You Earn Repayment Plan (PAYE), Revised Pay As You Earn (REPAYE), Income-based Repayment (IBR), and Income-Contingent Repayment Plan (ICR) after paying for 20-25 years. Hence, you could expect a student loan forgiveness “tax bomb” of between 10% and 37% of the amount forgiven, depending upon your taxable income after loan forgiveness.
Before we attempt to calculate the potential tax due on a forgiven or canceled loan, we should first address the possibility that all or a portion of the loan may not be taxable; the IRS defines these as “exceptions” and “exclusions”. IRS Publication 4681 (2017), Cancelled Debts, Foreclosures, Repossessions, and Abandonments addresses “Exceptions” and “Exclusions”. For purposes of this article, I am summarizing the most relevant parts.
Taxes and Student Loans: What are “Exceptions”?
When you have a loan forgiven, your lender will issue you an IRS Form 1099-C, which reports the amount of the forgiveness. This form is then attached to your tax return and included in your taxable income. Receiving a 1099-C usually means that you owe taxes on the amount, but there are cases in which you may NOT owe taxes on the forgiven student loan amount.
Sometimes a debt, or part of a debt, that you don’t have to pay isn’t considered canceled debt, and may qualify as an “exception”.
Exception for health care providers: generally, the cancellation of a student loan made by an educational institution because of services you performed for that institution or another organization that provided funds for the loan must be included in gross income on your tax return. However, there are two key exceptions:
- Repayment of student loans made to you by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act isn’t taxable if you agree to provide primary health services in health professional shortage areas.
- Amounts you received under any other state loan repayment or loan forgiveness program also aren’t taxable if the program is intended to increase the availability of health care services in underserved areas or areas with a shortage of health professionals.
What Are “Exclusions”?
After you have applied any exceptions to your forgiven or canceled loan, there are several reasons why you might still be able to exclude it from your income. As with exceptions, if a canceled or forgiven debt is excluded from your income, it is nontaxable. In most cases, however, if you exclude this amount from income under one of these provisions, you also must reduce your “tax attributes” (certain credits, losses, and basis of assets). Again, refer to IRS Publication 4681 for a detailed discussion of tax attributes.
Public Service Loan Forgiveness
Federal forgiveness programs like Public Service Loan Forgiveness (PSLF) excludes the amount from taxable income, and you won’t have to claim it on your federal tax return. Under this program, if you are employed by a non-profit organization and you meet the qualification requirements, then the amount of the forgiven loan is not considered as taxable income.
To qualify for this treatment, the loan must have been made by:
- The federal government, a state or local government, or an instrumentality, agency, or subdivision of one of those governments;
- A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law; or
- An educational institution: under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or as part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) (non-profit) organization.
Loan Forgiveness in the Private Sector (not including PSLF)
As previously mentioned, you may be required to report the forgiven or canceled loan amounts as taxable income (going forward, I’m using the term “forgiveness”). To understand this better, you should look at the 2018 federal tax table. It shows the new tax brackets*, and includes two MAJOR bracket shifts: from 12% to 22%, then from 24% to 32%.
Depending upon your income and the amount forgiven, your “tax bomb” could also cause you to shift into a significantly higher marginal tax bracket, a phenomenon known as “bracket creep”.
*Note that this only shows federal tax brackets; different states will have varying tax brackets, so be sure to factor your state income tax into the calculations.
Consider the following scenario: an individual reports taxable income after exemptions & deductions of $60,000, and has qualified for a loan forgiveness in the amount of $100,000 (all figures are approximate). The table shows the tax rates based upon his or her income in each bracket:
Before loan forgiveness, his federal income tax was $9,140. After loan forgiveness of $100K, his federal income tax is $32,890, resulting in a student loan forgiveness “tax bomb” of $23,751. Note that the last $2,500 of loan forgiveness pushed him into a marginal rate of 32%.
Consider the scenario in which a married couple filing jointly reports taxable income after exemptions & deductions of $80,000, and has qualified for a loan forgiveness in the amount of $200,000 (again, all figures are approximate). The table shows the tax rates based upon their income in each bracket:
Before loan forgiveness, their federal income tax was $9,479. After loan forgiveness, their federal income tax is $55,779, resulting in a “tax bomb” of $46,300. Hence, their $200K loan forgiveness is taxed at nearly 23%. In this case, the highest marginal tax bracket is only 2% more than the previous one. So, their “bracket creep” is not so bad, but they still have a hefty tax bill as the result of forgiveness.
Loan Forgiveness Due to Personal or Financial Hardship
Federal student loan borrowers who cannot work due to an illness or injury may have their loans forgiven or discharged due to total and permanent disability and furthermore could also avoid being taxed on the amount. Borrowers can qualify in one of three ways: with doctor certification, Social Security benefits, or certification from the Department of Veterans Affairs.
This last scenario recently made headlines in Michigan, when a wounded veteran had $223,000 of federal student loans forgiven, and then received a $62,000 tax bill in its place. So, he turned to his state and congressional representatives for assistance. A few months later, the Michigan Senate approved Senate Bill 642, to ensure that disabled veterans do not have to pay state income tax on student loan debt that was forgiven due to the veteran’s injuries.
Unfortunately, the IRS still treated debt cancellation as income, so he was being asked to pay federal income taxes on the entire amount, hence the federal tax bill remained $62,000. But Congress came to the rescue: loans that are forgiven on or after January 1, 2018, due to “total and permanent disability” are no longer reported as taxable income. The bad news is that the change, part of a massive overhaul of the tax code spelled out by the Tax Cuts and Jobs Act, is not retroactive.
Tax Forgiveness Due to the Insolvency Exclusion
If you don’t qualify for one of the relief options mentioned previously, then one of the only ways left to avoid the tax ramification of a student loan discharge is to apply for an insolvency exclusion. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. Currently, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.
Keep in mind that if you are eligible for an insolvency exclusion, it may not be for the full amount of your loan discharge. Also, bear in mind that these rules may change. You will need to complete IRS Form 982 to apply for this exclusion. You can estimate the value of the exclusion using the worksheet in IRS Publication 4681.
Are Retirement Accounts Protected from the IRS?
The IRS can seize retirement accounts, including 401(k) plans, IRAs, self-employed plans like SEP-IRAs, and Keogh plans. The key to defending retirement accounts from IRS seizure is to understand that the IRS “stands in your shoes”, which means that if you cannot get to the retirement money, the IRS cannot get to it either. Many retirement plans allow access to funds only at separation from service, retirement, or death/disability.
Thus, if you are still employed you likely have no ability to withdraw the retirement money, therefore the IRS has no ability to seize it. This may also apply to the company contributions to your 401(k) plans; however, the amount you personally deposited from your paycheck, as well as vested company contributions, may still be subject to seizure because you have access to these funds. Reference is found in Internal Revenue Manual 22.214.171.124, which governs IRS seizures of retirement accounts.
Default & Foreclosure Is Not a Good Idea
Never default on your taxes: doing so will trigger tax liens, and it will have a huge negative impact on your credit score as well as your ability to borrow money in the future. As far as a foreclosure on a home, it is generally (but not always) the case that the IRS will not foreclose on a home to collect taxes. Most tax courts will make provision for “reasonable living accommodations”, which means that you must be allowed to have a residence for you and your family to live in. Again, be sure to consult with an attorney or tax advisor if you find yourself in this situation.
General Guidelines on Loan Forgiveness
As a general guideline, you should pay as little as possible to get maximum loans forgiven, and have as much left over as possible. The consultants at Student Loan Planner typically use debt to income of 1.5 or more if you are applying for forgiveness.
You should also establish a bank account and make monthly deposits to provide a cushion for future payments or unanticipated events. Finally, you may be able to postpone the year of forgiveness into one in which your tax bracket will be lower, thus further mitigating the potential student loan forgiveness tax bomb.
Hopefully, this article has enabled you to have a better understanding of the tax consequences of loan forgiveness and provided you with a few guidelines & strategies to help you along the way. As always, manage your money wisely and plan ahead for contingencies.