Like millions of student loan borrowers, I’m working towards student loan forgiveness on an Income-Driven Repayment (IDR) plan, and like millions of borrowers, I need to prepare for the so-called student loan “tax bomb.”
Because a huge tax bill at forgiveness is only a possibility, I’ve devised a plan that will help me prepare for this possibility and maximize my options if it doesn’t become a reality.
Why Plan for a Huge Student Loan Tax Bill?
The Public Service Loan Forgiveness borrowers are the lucky ones. Not only do they get their student loans forgiven after just ten years, but the forgiveness is tax-free.
IDR borrowers are not as lucky. As the rules stand right now, many will have to pay taxes on the debt forgiven under IBR, ICR, PAYE, or SAVE. This is because the IRS’s general rule is to treat forgiven debt as income in the year it is forgiven. This rule has given rise to the term student loan tax bomb.
The recent stimulus package had a small student loan provision that could make a massive difference for some IDR borrowers. Loans that are forgiven between now and 2026 will not be taxed. Unfortunately, I won’t be reaching forgiveness that soon, so as the law stands, I still have to plan for a tax bill.
I’m optimistic this tax bill may not ever happen, but I don’t trust Congress enough to assume that I won’t have to worry about it.
My Tax-Bomb Plan is a Roth IRA
Right now, I’m saving money for an uncertain future.
I may need money for a large tax bill. Ideally, that bill never comes. Hopefully, I can set that money aside now and save it for retirement. In this scenario, a Roth IRA makes the most sense.
I use a Roth IRA for three reasons:
- It is an excellent retirement account.
- I can withdraw my contributions at any time without taxes or penalties, so if the tax bill comes, I have funds available.
- If I have some other immediate emergency, I can dip into this savings.
The unique and flexible rules of a Roth IRA make it the ideal type of account for this particular situation.
Roth IRA Flexibility vs. a Bank Savings Account
The top two options for my tax bomb plan were a standard savings account and the Roth IRA.
I was able to quickly eliminate options like a 401(k) or a Traditional IRA. Of the many different retirement accounts, the Roth IRA stood out as the best choice. Most other retirement plans impose a penalty for withdrawals before reaching retirement age. Because I may need the money in about ten years, these plans will not work.
Thus, the decision came down to Roth vs. a savings account.
The significant benefit of a savings account is that it is easy. Every bank offers one, and I can take the money out whenever I like. However, I see two major downsides. First, with that ease comes temptation. It would be easy to pull some money out of that account to make a purchase that isn’t necessary. Additionally, there are no tax benefits, and the interest rates on a savings account are terrible these days.
Having a Roth IRA means major tax advantages. The money inside a Roth account grows tax-free. If it ends up being a retirement account, I can use those funds without facing any tax considerations.
The Roth downside is that only contributions can be withdrawn penalty-free. In other words, if I put $10,000 into a Roth IRA and the balance grows to $10,800, I only have my original $10,000 contribution available for my student loan tax bill. The remaining $800 will have to sit in the Roth account until I hit retirement age… or I will have to pay a penalty on the $800 that got pulled out early.
However, the biggest advantage of the Roth IRA is that I can invest the money to grow my savings. I tend to invest conservatively because I may need the money in about ten years. This route is riskier than a standard savings account, but it has a higher upside. If we ever get more clarity on student loan taxes, I can also change my investment strategy to a longer outlook based on my retirement.
A Final Advantage: Funds in an Emergency
I’m a huge supporter of having an emergency fund. This especially holds true for student loan borrowers. If you depend upon high-interest credit cards to weather a financial hardship, it will be costly.
Many argue that a Roth IRA is an excellent supplemental emergency fund. Ideally, that money gets used in retirement. However, if you face desperate circumstances, the Roth account is a huge asset.
I hope to use my Roth IRA for my retirement. However, I’m ready to use my Roth IRA to pay a large student loan tax bill. If necessary, I have my Roth IRA for a major financial emergency.
I suspect many federal borrowers working towards IDR forgiveness will find a Roth IRA to be an excellent resource.