The total outstanding student loan debt in the U.S. has ballooned to over $1.7 trillion. As more students face the serious problem of rising debt, many are counting on loan forgiveness programs. But students, as well as Parent PLUS loan borrowers, need to be aware that student loan forgiveness could result in a huge tax bill.
Loan forgiveness basics
Even if you don’t complete your education, your lender expects you to repay your student debt. The same goes if you can’t find a job related to your program of study or if you’re unhappy with your education. This is true even if you were a minor when you signed your promissory note or received the loan.
However, certain circumstances might lead to your loans being forgiven, canceled, or discharged.
Loan forgiveness terminology
According to the U.S. Department of Education, the terms cancellation, forgiveness and discharge basically mean the same thing. But they’re used in different ways.
In each of these cases, the borrower is no longer required to repay some or all of the remaining amount owed.
For example, loan forgiveness usually applies to the Teacher Loan Forgiveness Program or the Public Service Loan Forgiveness (PSLF) Program. Under these federal programs, borrowers aren’t required to pay income tax on any canceled or forgiven amount due to qualifying employment.
Whereas, loan discharge generally refers to the cancellation of debt due to certain circumstances.
For example, this might include school closure, a school’s false certification of a borrower’s eligibility to receive a loan or a school’s failure to pay a required loan refund. It might also include 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 student loan payments previously made on the loan.
But depending on the type of discharge, the amount discharged may be treated as taxable income.
Loan forgiveness, cancellation and discharge scenarios
The following table illustrates the various types of loan forgiveness, cancellation, and discharge. It also shows how they apply to the various types of loans.
*FFEL Program loans and Perkins Loans may become eligible for PSLF if they’re consolidated into the Direct Loan Program.
Alternatively, you could qualify for discharge of your federal student loans based on “borrower defense to repayment”. This might be the case if you took out loans for tuition at a school that misled you or engaged in other misconduct in violation of certain state laws. If so, the school’s act or omission must have directly related to your federal student loans or to the educational services that you paid for with the loans.
Parent PLUS loans follow the same general guidelines. They can be discharged if the borrower dies, becomes totally and permanently disabled, or if the loan is discharged in bankruptcy. Your Parent PLUS loan may also be discharged if the child for whom you borrowed dies.
Note that these scenarios don’t apply to private loans.
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 you’ll likely be required to report this amount as taxable income.
Bear in mind that taxes on student loan forgiveness apply to all loans forgiven under income-driven repayment (IDR) plans after paying for 20 to 25 years. Therefore, you need to anticipate a student loan forgiveness “tax bomb”. This will likely involve writing a sizable check when your loans are eventually wiped away.
Before we calculate potential tax implications 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” in IRS Publication 4681.
Taxes and student loans: What are “exceptions”?
When you have a loan forgiven, your lender will issue an IRS Form 1099-C. This form is attached to your tax return as it reports the amount of your debt forgiveness.
Receiving a 1099-C usually means you owe taxes on the forgiven amount. But there are cases in which you may NOT owe taxes on the forgiven student loan balance.
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”.
Example of exceptions for health care providers
Generally, the cancellation of a student loan made by an institution because of services you performed must be included in gross income on your tax return.
However, there are two key exceptions:
- Student loan repayment made by the National Health Service Corps Loan Repayment Program isn’t taxable if you agree to provide primary health services in health professional shortage areas.
- Amounts you received under any state loan repayment or loan forgiveness programs 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.
It’s best to check with your program to confirm any tax implications, rather than assuming all funds aren’t taxable.
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” (e.g. certain credits, losses, and basis of assets).
Refer to IRS Publication 4681 for a detailed discussion of tax attributes.
Public Service Loan Forgiveness
Federal forgiveness programs like PSLF exclude the forgiven amount from taxable income. So, you won’t have to claim it on your federal tax return.
Under PSLF, if you’re employed by a nonprofit organization and you meet the qualification requirements, then the amount of the forgiven loan is tax-free.
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) 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.
Depending on your income and the amount forgiven, your “tax bomb” could also cause you to shift into a significantly higher marginal tax bracket. This is a phenomenon known as “bracket creep”.
For example, let’s say Tom is single and has $90,000 of taxable income. His 2021 marginal tax rate will be 24%. If he had $100,000 of student loans forgiven in the same year, his taxable income would increase to $190,000. His marginal tax rate would then jump to 32%.
This is something to keep in mind and prepare for ahead of time, so you aren’t stuck with a huge tax bill that you can’t afford.
Keep in mind that the American Rescue Plan made student debt cancellation tax-free through December 31, 2025. However, a limited number of borrowers will receive IDR forgiveness before this provision expires.
Income-driven repayment forgiveness examples
Consider the following scenario: an individual reports taxable income after exemptions & deductions of $60,000, and has qualified for income-driven forgiveness with a student loan balance 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 can’t work due to an illness or injury may have their loans forgiven or discharged due to total and permanent disability. And, furthermore, they could avoid being taxed on the forgiven amount.
Borrowers can qualify in one of three ways:
- Doctor certification
- Social Security benefits
- Certification from the Department of Veterans Affairs
This last scenario recently made headlines in Michigan. 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.
Unfortunately, the change 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 if you’re eligible for an insolvency exclusion, it may not be for the full amount of your loan discharge.
Also, bear in mind these rules may change. You’ll 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”.
This 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, death or disability.
Thus, if you’re 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.
For more information, review Internal Revenue Manual 5.11.6.2, which governs IRS seizures of retirement accounts.
Default and foreclosure isn’t a good idea
Never default on your taxes. Doing so will trigger tax liens. 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’s 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 and have as much left over as possible to take full advantage of student loan forgiveness. 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 given you a better understanding of the tax consequences of loan forgiveness and provided you with a few guidelines and strategies. As always, manage your money wisely and plan ahead for contingencies.
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has there been cases of couples filing separately and then later amend to filing together?
Yes but you only want to do it if you made a mistake and not as a typical strategy, or if you no longer have loans you can amend
Under Federal Perkins Loan Cancellation for Teachers, are cancelled amounts taxable to the recipient?
This might be an important nuance. Perkins loans are cancelled not forgiven via the route that would add them to income, so I’m pretty sure it’s non taxable
Will the canceled loans from the Career Education Corporation be taxed?
The Settlement: What Happened
Career Education, which operates the for-profit colleges Colorado Technical University and American InterContinental University and serves approximately 34,000 students, agreed to cancel $493.7 million in student debt for nearly 180,000 former students. The Illinois-based company faced allegations of fraud and deceptive practices, including allegedly misleading students about its job placement rate and actual cost of earning a degree, among other practices.
To be honest not sure about that. I would lean towards not being taxed but I’m double checking on it.
Thank you for looking into it!
I got a response from a student loan attorney Dionne. Here’s what he said:
I haven’t seen a student with a CEC loan that received a 1099. I believe the settlement required cancellation as opposed to discharge, so no 1099. If the borrower receives one, they should dispute it with CEC.
If that fails, call the IRS at 1-800-829-1040 and start a Form 1099 complaint. The IRS will send the borrower an IRS Form 4598, Form W-2, 1098 or 1099 Not Received, Incorrect, or Lost. The borrower would attach the Form 4598 to the tax return.
Wow. HUGE thanks for looking into this and doing it so quickly. SO grateful for your help!
How does one calculate the estimated percentage (Ex: 10-37%) of their loan forgiveness that would be taxed by the IRS?
The top tax rate you have when the loans are forgiven. It’s not predictable unless you know tax brackets in 2030s
Can the IRS seize Social Security Retirement Funds if you owe a substantial amount after student loan forgiveness?
Thank you.
That has never been tested before, but normal tax settlement rules would apply presumably if you have more assets than liabilities. If you only have social security then your tax is likely not due at all under the insolvency rule exemption.
a basic question, but, to be clear, outstanding principle and interest will be forgiven with PSLF, correct?
Has this been the intent of the program and have those who successfully filed gotten forgiveness for both principle and interest?
Correct
Not to mention that over 25 years these loans will accrue interest so your 40,000 loan could end up being a 150,000 loan by the time the period passes for forgiveness… Now you will be liable for an enormous amount of income taxes — it could even be higher – for those with 100,000 loans it could easily reach 500,000 or 600,000 — this problem needs to be addressed!
Student loan interest grows at a simple rate of interest because of government rules, so the most a 100,000 balance could become is around 300,000.
Thanks for your response. Can you please provide a citation to the tax code where PSLF is called out as tax exempt relief. I believe it is in the tax code but a cannot seem to find it now.
It isn’t cited here directly but this is a great place to search regs
https://www.law.cornell.edu/cfr/text/34/685.219
I was told prior to converting parent PLUS loans to a consolidated Direct loan, then qualifing for PSLF and tax forgiveness, that the only income based repayment option was ICR (for parent loans).
Now about a year after the changes, I’m told I can change from ICR and reduce payments by selecting PAYE, REPAYE, IBR plans but I’m fearful there is a downside.
What are your thoughts?
You have to do double consolidation, which is very difficult, so you’ll probably need to stick to ICR.
I am seeing mixed answer on the internet to my situation and really want to get the accurate answer. This year I found out about the ‘Closed School Discharge’ program and I was approved for that. My college closed my senior year for financial reasons and I never finished my degree. All of my federal loans were discharged and all payments I made for the last 15 years were returned to me.
The main question is, will I get a 1099 for that discharge and have to claim it as income?
There are answers of ‘yes’ and ‘not taxable’ all over the internet. I am just trying to find the answer that is correct.
I don’t believe you will. But if you did it would probably be a 1099-C. I would expect no tax from this.
Hello,
I have recently read that student loans discharged due to a total and permanent disability are no longer federally taxable if the three-year monitoring period fell within certain years. Do you know if the State of Indiana will tax the amount discharged? My three-year monitoring period ended in 2019. Thank you for your help!
That’s a tough one do you mean private loans or federal? Federal is now tax exempt as of 2017. Private I believe is still taxable when forgiven.
I was referring to federal loans. I have asked the Indiana Department of Revenue twice about this. One time they said that I would be taxed from the State, and the other time I inquired about this, they said I would not be taxed. I have even consulted a few CPAs, and they seemed to believe I would not be taxed by Indiana, but they did not seem confident. I am at my wit’s end. I appreciate your response.-Cindy
If you are taxed, you’ll receive a 1099-C. I’d ask a CPA to see if you could qualify for an insolvency exclusion, which would mean your assets are lower than your forgiven debt. In that case it’s likely it’d be forgiven tax free at all levels. I’d also suggest asking a student loan attorney like my friend jay@moneywiselaw.com
Cyndy,
I have a similar situation, TPD with outstanding Federal Student Loans which are exempt from taxed by the IRS. However, I have not yet contacted the State of Indiana Treasury. My 3 year monitoring period has just started, so I have a little time to find out what will happen. I would greatly appreciate if you could keep me updated on what you find out and if you the State of Indiana charges you a tax on your discharged loans. Where did you go to contact the right people as I know it can be very confusing? Do you have a phone number?
Thanks for taking the time to read and consider helping me figure something out. Have a Merry Christmas,
Todd
Hey
As you mentioned, the safest way is to pay minimum now and set up an account to pay the massive tax later in life, and we never know what will be the taxes in the future, it could be higher or lower.
Can you mention again what kinda loans will not have “tax bomb” issue?
Direct loans that are paid via the PSLF program are tax free when forgiven. Otherwise you have to pay tax on anything forgiven.
What about loans that are repaid with an IBR and are also in the PSLF program. Will the dishcharged amount be taxable or not?
Not taxable
i have applied for my Student loans to be permanently disabiled i saw that i may get taxed by the state need advice thanks
i live in West Virginia
I participate in a Federal Nursing Loan Repayment Program as part of the Nurse Corp administered by the Health Resources and Services Administration. The website distinctly says that the funds are taxable. I receive a 1099-C. Above you indicate that these funds are exempt. Does this mean that Federal govt doesn’t tax it but states can choose to or not? How should I proceed, because right now I’m looking at a $6000 tax bill!!
We clarified it above you’re correct tried to make it more clear now
Thank you for your input. I learned a lot. Is my assumption correct, that you have to pay taxes on canceled loan and interest or loan only? We have 154k student loan at 6% interest. If we keep IBR payments our loan will skyrocket to 600K, do we pay taxes on the 600K or original loan of 154?
It’s the full amount, but bc interest doesn’t compound it accrues so that balance will likely double not quadruple. So the tax bill will be much lower.
So, I’m quite concerned for various reasons, but I have a specific question. At this moment, my husband owes almost $200,000 in student loans thanks to compounding interest, and is in the REPAYE program. We have given up trying to pay it off. That means our “forgiveness” will be an order of magnitude that I don’t wish to think about. Suffice it to say, my best guess is that in the future, the amount forgiven will put us in the 37% tax bracket if the bracket remains as it is today. We will need to, naturally, make payments to the IRS until we die because we’ll never pay off the tax burden before we croak because it will be so huge. My main question is whether or not the actual tax burden associated with the forgiven loans is subsequently forgiven if my husband dies, or if, when he dies, I’ll have to keep paying the taxes until I also die. I mean, if he dies before the tax bill comes due, the whole amount is forgiven. Seems like any taxable amounts related to those loans should also be forgiven, but I’m guessing the government hasn’t thought of the little old ladies poorer than dirt trying to pay their dead husband’s gigantic tax burdens in old age. I’m terrified they’re going to come after my 401k that’s in my name if we are married filing jointly. Maybe that year we file separately? Will that take care of the death issue? Ugh.
Most of our clients have this concern and when they hire us we explain it to them and then they’re not worried about it anymore (studentloanplanner.com/help)
Yes it’s forgiven in event of death but realistically you just need to save a few hundred a month in a brokerage account and will have enough to cover the tax payment. Also the interest on REPAYE in not compounded it grows at a simple rate of interest. Long explanation as to why.
How is interest considered income? Wouldn’t the forgiveness be based on the face value of the loan amount?
Interest is the cost you pay to borrow the money, so it becomes part of your final bill that’s due – which is why it’s included in the taxable forgiveness.
Hi,
I’m sure this has been asked before but I can’t seem to wrap my head around this. Lets say you’re in the 10% tax bracket (pre-student loan forgiveness) and you have $500k+ of student loans forgiven this year. Does that mean your tax bracket jumps up to 37%? Thanks.
The tax bomb is a concern of many borrowers. In our podcast episode number 79, Travis addresses this by saying “If the tax bomb ruins your finances, I’m going to be stunned. The IRS code has something called the insolvency rule. Basically, if your assets are less than your debt, you don’t owe the taxes on the debt. A good CPA can get the debt discharged.”
So, if after 20 years I owe $1,800,000 but only have $1,500,000 in assets, then will entire loan will be forgiven with no tax bomb of $900,000? Also, can the IRS change this code?
Thanks
That’s a great question for a tax professional. In theory, that’s how it works but it isn’t so cut and dry.
My private student loan by Chase in 2009 was forgiven and a 1099c filed December 31st 2017. The IRS states i now owe taxes on that amount. I am permanently and totally disabled. I married my spouse in 2015. We filed jointly in 2018. She is a federal employee as a n RN. They have attached the debt to her also. If the 1099c had been filed 24 hours later I would not owe taxes. We have 3 kids under 18.
In a nut shell, what can I do?
Reach out to these guys https://studentloantaxexperts.com/ and mention SLP as the referral source for a discount if you decide to hire them.
Amy,
Thank you for the studentloantaxexperts.com site. I will be in touch with them next month. Happy Holidays!
Todd
You’re welcome – happy new year!
For the insolvency exclusion – Is real estate debt considered a liability? If I make a low down payment to buy one or more investment/rental properties prior to the year of expected taxable forgiveness, I would have hundreds of thousands of dollars worth of new debt which be considered a liability. Could this be a strategy to qualify for at least full or at least partial insolvency?
You’d want to consult a tax professional to ask about specific scenarios. You definitely don’t want to be accused of tax fraud, so strategies like that should be vetted by a professional.
How would someone push off their standard forgiveness tax year?
I currently have been in repayment for 5.25 years. My initial loan was 195k…now it is at 270k. I am on a PAYE 20 year plan with forgiveness at end of term..
If in 5 years my loan has grown by 75k, what will it be in 15years? Im estimating that original 195k will be close to 500k at end of the 20 year tem in the year 2035 .
What should I do? My fogiveness will probably be close to 400k??
Any advice on how to go about this.
I currently desperately seeking a Public Servive Job in order to obtain “true” untaxed FORGIVENESS.
I suggest you book a consult with someone on our team to review your plan. It can give you peace of mind about your repayment plan so you’re not so anxious about the tax bomb.