For many of us, income-based repayment is a great option for our student loans. Instead of receiving a debilitatingly high bill each month, we are charged an amount based on what we earn, typically making payments much more manageable. Then, after 20-25 years of on-time payments, our loans are forgiven. Voila!
Surprisingly, what happens next is often not discussed… Don’t kill the messenger – it’s not pretty.
In many cases, the money you receive to pay off your loans is considered taxable income.
What?! I know… What does this mean?
Let’s say you have $100,000 in debt when your student loans are forgiven. That $100,000 gets added on as taxable income for federal and state taxes. Our tax rates vary but for simplicity let’s say you have no other income or deductions. You’d be in the 25% tax bracket for federal taxes alone. That’s a $25,000 bill.
Side note: In many cases, the amount we pay towards our loans only covers principal or part of the principal so our loan balances increase over time. After 20-25 years these balances can really add up. The debt that’s forgiven can be double, triple, even quadruple what we started out with.
So what happens if you can’t pay the taxes on your student loan forgiveness? The IRS puts you on a payment plan. Essentially, the IRS offers you a new loan for your tax bill.
Bye bye student loan debt, hello tax debt.
Teachers and those in public service can sigh in relief. Right now, these are the only types of loan forgiveness that are exempt from taxes.
What you can do.
Guesstimate how much you will owe at the time of forgiveness. This will be a rough estimate, especially if you are still pretty far out but this way you can get an idea of how much you want to be saving.
Then, create a tax investment or savings account and regularly transfer money over. If you are not sure where you will find the money to save, start small. What matters most is that you start. If you are still a ways away from forgiveness, invest your savings so that it will grow and make it much easier to hit your goal.
Who knows what the future will bring. The silver lining is that although this is the current law, laws do change. By the time your loans are forgiven, forgiveness might not be taxable. But, in the case that nothing changes, it makes sense to start planning and saving early. If something changes and you don’t need the tax money you’ve put aside, you can use it for something else!
Please share this with anyone you know with student loans, who may have opted for income-based repayment.
Friends don’t let friends get bamboozled by tax bills!