How To Avoid the Tax Bomb on Your Student Loans

With president-elect Joe Biden’s upcoming transition into the White House, we may be closer to tangible student loan forgiveness than we have ever been. But regardless of whether Biden enacts an executive order or Congress passes legislation, loan forgiveness will be counted as taxable income. “Loan forgiveness might substitute a (smaller) tax debt for the student loan debt,” says Mark Kantrowitz, publisher for  PrivateStudentLoans.guru.

[ Read: The Best Student Loans of 2020 ]

In the long run, loan forgiveness will help 44.2 million people who carry student loan debt. But a hefty tax bill could be a detrimental trade-off. Sens. Chuck Schumer, D-N.Y., and Elizabeth Warren, D-Mass., have pointed to lawmakers’ ability to ensure no tax liability for borrowers.

Current tax-free debt forgiveness

Without action from lawmakers, you would owe taxes for anything forgiven. There are a few instances in which the student loans that are forgiven are tax-free. 

1. Public Service Loan Forgiveness — A far from perfect program, PSLF forgives the remaining federal balance of government and non-profit workers after 120 consecutive monthly payments.
2. Borrower Defense to Repayment — In January, the IRS and Treasury Department finally gave defrauded students tax relief. Included are closed school discharges and unpaid refund discharges. 
3. Death or permanent disability — Tax Cuts and Jobs Act of 2017 made death and disability discharges tax-free through 2025.

Here’s what you can do to prepare

Do your research

Borrowers on an income-driven repayment plan for their student loans will likely be hit the hardest by an inflated tax bill. There are still some things you can do to offset the burden. To start, you should get a realistic view of how much you would owe. You can use the repayment estimator to get an idea of your loan forgiveness amount. Depending on the tax bracket you fall under and the amount forgiven, many people will not have the extra thousands on hand to pay off that tax bill. 

[ Read: Should You Bank on Student Loan Forgiveness in 2021? ]

The IRS offers options that allow you to either pay off or settle for a lower amount in certain situations. When reaching this step, it will feel like you are taking on more debt to settle another, though the financial relief associated with student loan forgiveness will be worth it. Familiarizing yourself with the options the IRS offers will make sure there are no surprises.

• IRS form 982 — The IRS may choose to forgive tax debt if the person is insolvent –– meaning the debt they carry outweigh their assets. 
• IRS form 656 — You can apply for an offer in compromise to settle for less than the full amount. There is a $205 application fee to complete the process. 
• IRS form 9465 — A repayment plan offered by the IRS that is available for up to six years. Fees and interest will be charged on your balance. 

Start saving now

We can’t say for certain if loan forgiveness will actually happen, but prioritizing savings is never a bad idea — especially with a tax payment looming overhead. Whether you scale back to the minimum payment on your loans or cut back on your spending, preparing for a bill will save you headaches when tax season rolls around. Even an extra $50 a month in savings is better than nothing. 

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