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Tax-Free Student Loan Forgiveness: What it Means for Borrowers with Large Balances

If you look at Section 9675 of the American Rescue Plan, you'll find one of the most important changes ever to student loan policy in America. Borrowers receiving a discharge on their student loans will no longer have to pay income taxes on that discharge through December 31, 2025.

Besides making student debt cancelation tax-free, this also means anyone receiving student loan forgiveness after 20 to 25 years of income-based payments would also owe $0 in taxes.

That's a big difference from IRS code in the past, which stipulated that student loan forgiveness should be considered taxable income unless the program specifically states otherwise, such as with Public Service Loan Forgiveness (PSLF).

There's good news and bad news for borrowers with large student loan balances. While this change could create a precedent that becomes permanent, Congress is likely focusing on the short-term impact of student loan cancelation instead of long-term forgiveness from income-driven repayment.

Additionally, the American Recovery Plan that made student loan forgiveness tax-free is a bill supported by Democrats only. It thus had to be passed using a technique called budget reconciliation, which means this policy change had to be temporary.

We'll explain what tax-free student loan forgiveness in 2021 to 2025 means to you, and what changes you might make to your student loan repayment plan.

Student debt cancelation is the primary reason for changing tax treatment of student loan forgiveness

President Biden has repeatedly said he supports canceling $10,000 of student loan debt as a response to the Coronavirus pandemic.

However, he has stated that he does not believe he has the authority to cancel student loan debt through executive action. He has also stated that he does not support canceling a higher amount of $50,000 as Senator Schumer and Senator Warren have proposed.

Regardless, this student loan cancelation would have to be considered taxable income under current IRS code.

The primary reason for addressing taxation on student loan forgiveness now is because Democrats want to pass at least some form of student debt cancelation this year without having it incur income taxes, which would be counterproductive as the potential tax bill would have been larger than the monthly payments in many cases.

However, making student loan discharge tax-free also affects borrowers using income-driven repayment who expect to have their loans forgiven.

That's why so many borrowers are excited about this change.

However, I would temper my enthusiasm if I were a borrower with a six-figure student loan balance.

Making income driven repayment forgiveness tax-free looks cheap until opponents realize it's not

Yes, the Senate did decide to eliminate taxes on student loan forgiveness.

However, they did not do so specifically because of borrowers pursuing IDR. I think they likely did it primarily because of the student debt cancelation they hope to achieve. Then, a very smart Democratic Senator realized they could add in discharge for income driven repayment in hopes of creating a precedent.

This was easy to do because the Joint Committee on taxation found that this would cause Congress to forgo $44 million of revenue until December 31, 2025.

That projection is so small because the only borrowers eligible for forgiveness in the next few years need to have been on an income-driven plan already for at least two decades. These borrowers only had access to Income Contingent Repayment, or ICR, which is an impossible and difficult option to navigate.

So, the cost for making this change looks cheap because taxation of forgiven student loans does not affect many people during this window in the American Rescue Plan.

However, if you're a Republican Senator opposed to widespread student debt cancelation, you can bet there will be strong opposition to it once this provision expires in 2026.

How strong will the precedent be for making student loan forgiveness tax-free permanently?

Both parties frequently add in provisions to the budget with expiry dates. That way, you can pass priorities without needing 60 votes in the Senate.

That's how the Republicans attempted to repeal the ACA, and it's how they succeeded in passing sweeping tax cuts under the Tax Cuts and Jobs Act.

So how strong would the precedent be for making tax-free student loan forgiveness permanent?

Very few borrowers will receive tax-free student loan forgiveness by 2026

If we were going to see hundreds of thousands of borrowers receive tax-free forgiveness on their income-driven repayment (IDR) plans between now and 2026, then I'd say this precedent would be very strong.

However, I believe all we will see as a result is no tax bill for a narrow $10,000 of student loan cancelation and a few thousand borrowers who will not need to pay taxes on their ICR plan forgiveness.

Furthermore, anyone eligible for ICR forgiveness in the 2020s probably would have qualified for forgiveness under the insolvency exclusion already. That provision allows borrowers who owe more than they have in assets to pay $0 in income tax on canceled debt.

Hence, we will see a tiny number of borrowers actually receive forgiveness under this change. This is not a strong case for precedent.

Comparing this tax change to the Trump tax cuts

I mentioned earlier that the American Rescue Plan was passed without any Republican votes. The same can be said of President Trump's Tax Cuts and Jobs Act.

The tax cuts in that bill expire at the end of 2025. If Democrats control both Houses of Congress and the White House at that time, you would assume there's a zero percent chance these cuts would be extended. Even if they controlled one of the three, they could still block an extension of these tax cuts.

Likewise, student debt cancelation is not something that Republicans generally support. Hence, if Republicans control any of the House, Senate or White House in 2025, they could block an extension of tax-free student loan forgiveness.

Losing Student Loan Forgiveness Taxation as a Bargaining Chip

I think it's likely that moderate Senate Republicans could support eliminating taxes on forgiven student loan debt. However, they would be unlikely to give that away without extracting concessions on limiting the amount of student loan debt the government can lend to an individual borrower.

That's another reason why I think that Republicans would not want to extend this provision and make it permanent in the absence of sweeping bipartisan student loan reform.

Effects of eliminating taxes on student loan forgiveness

I'm not exaggerating by stating that eliminating taxes on forgiven student loan debt permanently would be one of the most significant changes in the history of student loan policy in America.

Anyone, regardless of background, could obtain any credential they desired at the simple cost of an income tax.

However, universities would have carte blanche to charge ever increasing sums for access to education.

Benefit to borrowers from less wealthy backgrounds seeking upward mobility

Imagine that you're the first in your family to go to college, and that you eventually decide to go to medical school.

You face more financial obstacles than someone whose parents have saved enough for their child to attend their state's public medical school option.

Right now, borrowers from poorer and racially underrepresented backgrounds are disproportionately more likely to carry larger balances.

We see this anecdotally in the thousands of borrowers we've advised with student loan planning.

If student loan forgiveness was made tax-free permanently, it would benefit a lot of borrowers of color and borrowers from poorer backgrounds.

So, we can say that this would encourage access to education. However, the benefit would also accrue disproportionately to borrowers who attended graduate school. These borrowers have incomes that are significantly higher than average.

Moral hazard incentive for universities and students

A major concern regardless of your politics from making student debt forgiveness tax-free is the moral hazard it creates.

Borrowers had an incentive under income-driven repayment not to borrow too much, less it be considered taxable income when forgiven.

Realistically, this did not put up much of a speed bump in the growth of student loan debt.

However, many students do not understand that the tax bomb of student loan forgiveness is nothing to be afraid of. You can save for it by investing monthly in index funds over several years.

However, that's not a simple thing to explain in a couple of minutes.

A borrower who knows he will only have to pay 10% of his income for 20 years has no incentive to limit his cost of attendance. In fact, why would you not pursue the most expensive degree possible if it meant receiving the best education?

Universities understood this even better than borrowers. Higher education institutions have already drastically increased their tuition costs, in large part because they know borrowers can pay a percent of their income and avoid default.

Universities could continue the unsustainable increase of tuition if borrowers face no incentive not to borrow as much as possible.

Should borrowers expect tax-free forgiveness under income-driven repayment?

For at least a couple of years, we have urged borrowers to consider the impact of tax-free student loan forgiveness on their repayment strategy.

Even though the current policy might be that no taxes are due on canceled or forgiven federal student loan debt, that's only until the end of 2025. Here's our thoughts for borrowers planning to pursue forgiveness.

Plan like you still owe the tax

Since the bill that makes student loan forgiveness tax-free expires in 2026, you should plan like you still owe taxes on income-driven repayment.

Most Democratic lawmakers support the idea of making income-driven repayment forgiveness tax-free, but most Republican lawmakers do not (or else it would have happened permanently already).

That means a lot hinges on control of Washington after the 2024 general election. That's what would be needed to extend this provision into the mid-2030s so that enough borrowers would receive forgiveness to create a strong precedent.

Consider that your student loan forgiveness could be tax-free before refinancing

We used to advise borrowers if they owed less than two-times their income in federal student loans and worked in the private sector, they should refinance to a better rate.

Then we changed that guideline to say that you should refinance if you owe less than 1.5 times your income instead of two.

That's because we watched as the Prosper Act went nowhere, even though Republicans controlled Congress and the White House.

When President Biden won the election, we changed that advice yet again to say that you should refinance if you owe less than 1.25 times your income.

For our clients, we're already letting them know our latest thinking in terms of how best to pay down student loans.

Note that you could certainly refinance if your debt to income ratio is higher than 1.25. You just need to carefully weigh the pros and cons, including with taxes.

Policymakers have made paying back student loans less and less attractive for borrowers with high balances. That's because income-driven repayment has become increasingly generous over time, and policymakers might try and pass student debt cancelation.

Regardless of your support of opposition to these policy trends, you absolutely want to take them into account when deciding how best to pay back your student loans.

Expect more scrutiny of student loan forgiveness programs in the future

Congress tends to tighten eligibility and make federal programs less generous when faced with an immediate cost.

As the cost of student loan forgiveness continues to balloon over time to many multiples of initial projections, borrowers should expect that policymakers and Congress will consider making sweeping changes at some point.

However, these changes would likely only impact future borrowers, not current borrowers.

In the event student loan reform did affect current borrowers, it would likely be because student loan forgiveness benefits would be more generous, such as with the creation of Revised Pay As You Earn (REPAYE), Pay As You Earn (PAYE) and Income-Based Repayment (IBR).

The path to getting your student loans forgiven will be filled with a lot of noise. You simply want to make sure you have a clear plan so you can tune out what doesn't affect you.

And prepare as if you will still owe taxes on your forgiven student loan debt while knowing that it would be quite likely that taxes would not be due.

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