If you don’t know what a student loan forgiveness tax bomb is, consider the term a mixed blessing. On the one hand, the government is giving up your student loans, but on the other hand, the government is making you liable for a heavy tax bill on the amount of money that is forgiven. This is because the canceled debt is treated as additional income.
With student loans exceeding $ 1.4 trillion in the United States, more borrowers are relying on loan forgiveness programs to help erase some of their growing debt. While the idea of getting rid of your debt seems obvious, many students and their parents are caught off guard once the tax bill arrives. The taxes on this canceled debt are not cleared and you must report it to the IRS as income.
Who is facing a student loan forgiveness tax bomb?
As April 15 approaches, it’s worth discussing who’s really at risk from a student loan forgiveness tax bomb on the road so there aren’t any surprises. Borrowers who have difficulty making their payments often lean towards a income based repayment plan. These plans help you when your monthly debt exceeds your monthly income.
WHAT QUALIFIES YOU FOR STUDENT LOAN Forgiveness?
With income-based repayment plans, you can make very low payments for 20 or 25 years, depending on how much money you earn. But a little realized fact is that borrowers enrolled in income-driven repayment plans are also the most likely to be affected by the surprise and oversized tax bill. Once the repayment period is over, the remaining balance is canceled, and at the same time it is considered taxable income.
You will likely get a student loan tax bomb if:
- You signed up for an income-based repayment plan.
- You have not paid your entire balance within the allotted time.
You probably won’t get a student loan tax bomb if:
- Your employer gives up your loans through one of the many programs depending on your current industry. Many programs do not apply tax on debt forgiveness. This includes the Teacher Loan Forgiveness program, the Public Service Loan Forgiveness program, and the National Health Service Corps Loan Repayment Program.
- You have a Perkins loan that was canceled because of your employment or volunteer service or because of other conditions. These canceled loans are not subject to tax bills.
- You have been the victim of a scam or fraud on the part of your educational institution or if the college has closed its doors for good.
- You become permanently disabled or die.
How much will I have to pay?
While what you’ll have to pay will vary depending on your loan amount, remaining balance, and current income at the time, the following example gives you a good idea of how the tax bomb works:
Suppose a borrower earns $ 60,000 per year. This same borrower is eligible for a $ 100,000 loan forgiveness under one of the programs. Before the loan forgiveness income, his federal income tax was $ 9,140.
HOW STUDENT LOANS MAY AFFECT YOUR CREDIT RATING
However, after his $ 100,000 loan forgiveness, his federal income tax climbed to $ 32,980. This is because the extra income pushed him into a higher tax bracket. It equates to a huge tax increase, a bombshell, which he might not have expected.
Check with a tax professional to see if your state taxes will also be affected, as these can vary.
How to prepare for a forgiveness tax bomb
If you know you’ll be hit by a student loan forgiveness tax bomb, don’t worry, because planning now will save you some frustration in the long run. Here are some ways to plan so you don’t get caught off guard when it’s time to pay the IRS.
- Check it out handy reimbursement calculator to get a good idea of the amount of your student loan payments as well as the total amount of the forgiveness.
- Start saving money now. Even just $ 25 a month will go a long way in starting to save in the long run when that IRS bill comes due. This is all the more true since you have a good 20 years to prepare and save. At that amount, you will have saved $ 3,000 after 10 years and $ 6,000 after 20 years.
Options when you can’t afford to pay the bill
If the tax bill arrives before you are ready to pay, you can set up a payment plan with the IRS. There will be interest payable on the plan, but it’s better than the alternative if you don’t have the funds.
It should also be noted that more and more companies are recognizing the problem of student debt that is affecting their employees. If you are lucky enough to work for a company that helps you pay off your student loans, be sure to take advantage of the program. If you are looking for a job you may want to keep an eye out for companies that offer student loan repayment benefits.