A “student loan forgiveness tax bomb” occurs when your loan balance is forgiven and you have to pay taxes on that amount. This mainly affects borrowers on income driven repayment plans.
In this situation, you could face a potentially large tax bill that must be paid in full immediately. The best way to prepare for this is to estimate your planned student loan cancellation and put money aside early for that future tax bomb.
Who’s Facing a Student Loan Tax Bomb?
Borrowers who use income-based repayment plans are most likely to suffer a student loan forgiveness tax bomb. These plans last 20 or 25 years, and if you don’t pay off your loan during that time, your remaining balance is written off, but taxed as income.
If you receive a rebate under another federal student loan program, it will likely be tax exempt. You will not be faced with a tax bomb in the following situations:
You die or become totally and permanently disabled. This applies to you or the student loan recipient, in the case of parent PLUS loans. In the event of payment in the event of death, your estate will not be taxed.
Your Perkins loans are canceled. If you taught or performed any other job or volunteer service eligible for the Perkins Loan Cancellation, you will not be taxed on this amount.
Many states offer their own student loan exemption programs. For example, the Maine Dental Education Loan program offers qualifying dentists up to $ 20,000 per year in the form of a forgivable loan. Such programs are generally tax exempt, but check with the program operator or a tax professional to understand your liability.
If you have a canceled student loan, you should receive a debt cancellation form, known as Form 1099-C, for your taxes.
How much are you going to pay?
The size of a tax bomb for student loans depends on the amount forgiven as well as your finances in general. In some cases, the canceled student loan could cause you to tax bracket – further increase your tax burden.
For example, let’s say you are married, file your taxes jointly, and have two dependents. If your taxable income was $ 100,000 and you claimed the standard deduction, you would fall into the 12% tax bracket and owe $ 4,684 in taxes.
But let’s say you also had $ 50,000 in canceled student loans. This additional income would drop your federal return into the 22% tax bracket, which would bring your tax bill to $ 15,349, a difference of $ 10,665.
This additional income can also affect your state taxes. Some states do not have income tax, and Minnesota, for example, does not tax amounts waived under income-based repayment plans. Find out from a tax expert about your situation.
How to prepare for a forgiveness tax bomb
If you think you won’t pay off your loan in full over 20 or 25 years, use that time to prepare for the fallout from a potential tax bomb.
Estimate your bill. Use the Reimbursement estimator on studentaid.gov to project your loan forgiveness amount. Tax brackets can change over time, but examining your earning potential with data from the Bureau of Labor Statistics can at least help you estimate how much you will eventually owe.
Choose the right package. When deciding between income-oriented plans, many factors are important, such as your degree and marital status. Review compensation as you earn, or REFUND, may make more sense if a possible forgiveness is likely. This plan offers the best interest bonus, which can help keep your balance from skyrocketing.
Focus on savings. Instead of paying extra on your loan, invest the money with your rebate tax bomb in mind. For example, set aside $ 50 per month for your eventual bill. This small amount may not reduce your loans, but after 25 years with only 2% compound interestt, you will have saved over $ 19,600, which is hopefully enough for your tax bill. A savings goal calculator can help you determine how much to set aside.
What if you can’t afford your tax bill?
If you’re on an income-focused plan, you might not have money to put aside for a possible loan forgiveness tax bomb – not to mention things you actually want to save for, like buying a loan. home or retire.
Payment plans are available if you cannot pay your tax bill. IRS Payment Plans charge fees and interest, and rates may change every three months. In the first quarter of 2020, the interest rate was 5%.
In some cases, if the IRS considers you insolvent – or having debts that exceed your assets – you may be able to exclude some or all of the forgiven amount from your income. Speak with a tax professional once your loan is canceled to find out if this option is right for you.