Out of the fire and into the frying pan: borrowers may face a huge tax bill after they finally earn student loan forgiveness. It’s often called the student loan tax bomb.
The good news is that this hefty tax is often avoidable.
Unfortunately, not all borrowers will dodge the student loan tax bomb. It is a significant drawback to forgiveness and something that any borrower pursuing loan forgiveness should understand.
Student Loan Tax Bomb Origins
The origins of the significant tax bill on forgiveness can be traced to a single IRS rule.
The IRS treats forgiven debt as income in the year it was forgiven.
In many cases, this rule makes sense. If I work for Visa and Visa chooses to forgive my credit card debt as a bonus, it’s fair to tax that forgiveness as income.
Likewise, it wouldn’t be fair for employers to “loan” their employees’ money each week and then “forgive” it later to avoid taxes.
Student Loan Forgiveness Isn’t Taxed – For Now
The good news for many borrowers is that student loan forgiveness is a notable exception to the rule taxing forgiven debt.
Sadly, this particular exception ends on January 1, 2026 for many types of student loan forgiveness. In other words, if you reach IDR forgiveness before 2026, you are in the clear. If you are making payments on the SAVE plan until 2029, there could be a large tax bill in your future.
PSLF Special Exception: Unlike IDR forgiveness, PSLF tax-free forgiveness is permanently written into the tax code.
If you expect to earn PSLF forgiveness in 2030, there won’t be a huge tax bill waiting.
The Rules After 2026 and Planning for the Worst
Starting January 1, 2026, the temporary rules expire. At that point, forgiveness under income-driven plans like SAVE and IBR gets taxed.
While 2026 may seem like a long way away, many borrowers do not expect to earn forgiveness until after this date.
For this reason, it is crucial to plan for the possibility of a large tax bill.
As a borrower who doesn’t expect to earn debt relief until after 2026, I’m using a Roth IRA to plan for my tax bill. If I get a tax bill, I’ll have money saved and ready to go. If I don’t get taxed, I have extra money for retirement.
Those that don’t want to get fancy can also utilize a high-yield savings account. With interest rates currently starting around 5%, the money set aside for a potential tax bill has the opportunity to grow.
The Rules on Debt Cancellation Should Change
Even though student loans have become a politically-charged topic, there are some areas where both parties seem to agree.
Taxing loan forgiveness is one area. Without bipartisan support, the temporary rule eliminating the tax until 2026 would never have passed.
I’d argue that parents with Parent PLUS loans have the most persuasive argument against taxing relief.
Under the Parent PLUS rules, parents are protected in the event of a tragedy. If the child for whom the loan was borrowed dies, any remaining Parent PLUS debt is forgiven.
Before the tax rule changed, these parents got hit with large tax bills. It was an outcome that was both tragic and unfair.
While it’s hard to predict the future and especially hard to predict where the political winds may blow, I’d expect the tax on loan forgiveness to eventually get permanently eliminated.
How to Calculate Your Student Loan Forgiveness Tax Bill
Projecting a potential student loan forgiveness tax bill is a tricky business.
For starters, we don’t know whether or not this tax will exist.
If we assume the worst, we still don’t know what tax brackets will look like that far into the future. Additionally, it’s nearly impossible to project income far into the future.
In 2023, tax rates ranged from 10% to 37%. If you were taxed on $1,000 of forgiveness in 2030, and the tax rates remained the same, you would owe the IRS between $100 and $370.
The borrowers with the largest loan balances could be looking at tax bills of over $100,000!
State Taxes on Federal Loan Forgiveness
Federal taxes are not the only issue that borrowers need to consider when considering the financial impact of loan forgiveness.
Many states follow the IRS rules on loan forgiveness. In these states, there is no tax, but it changes in 2026.
Other states don’t follow the IRS rules on determining income. Some of them currently charge borrowers a tax on the forgiven debt.
For this reason, borrowers who successfully earn student loan forgiveness can opt out. For some, the potential state tax bill is unaffordable, and opting out of the relief is the only option.
Tax Rules to Avoid the Massive Bill
Within the IRS rules, there is a massive exception to the tax on the forgiven debt.
Some states may offer a similar rule.
For planning purposes, this is another situation where planning for the worst and hoping for the best is the right approach. Don’t assume you can avoid the tax via the insolvency exception until you get the green light from an accountant.
Sherpa Tip: Because there are federal and state tax laws to consider, it is an excellent idea to talk with an accountant if you are nearing forgiveness.
A good accountant can help you understand the latest tax law developments and minimize the tax bill.
If you have a large amount of debt that is about to be forgiven, speaking with an accountant could be money very well spent.
Minimizing the IDR Forgiveness Tax Bill
The more debt that gets forgiven, the larger the potential tax consequences.
For borrowers with large balances and lower monthly IDR payments, their balance may be growing each month.
In this circumstance, the new SAVE plan is an excellent option to keep the tax bill down. On the SAVE plan, borrowers receive a generous subsidy to keep the balance from growing.
Those who qualify for $0 per month payments have an effective interest rate of 0% on the SAVE plan.
The SAVE plan will help borrowers keep their balances from growing. Once these borrowers earn forgiveness, the amount forgiven will be smaller, and the potential tax bill will be more affordable.
All IDR borrowers should take some time to investigate the new SAVE plan, estimate potential monthly payments, and get signed up when appropriate.
Thank you for all the work you do on this site. It is the one with the best information out there that I have found. I am struggling with the decision on whether or not I should change from PAYE to SAVE. CON: Change from 20 to 25 years repayment; so 10 more years/age 63 or 15 more years age 68. PRO: With the SAVE interest rules I believe the amount forgiven(therefore the amount I may be taxed on) may be drastically lower on SAVE. I am not sure how to calculate if this is true. I currently have a debt of $130K of grad school loans. I pay about $150 a month based on my current income with PAYE. I feel like I need help to figure this out. What type of professional can I reach out to, to assist me with this calculation and decision?
The SAVE vs PAYE question is a really tricky one for borrowers like you. This morning, I published an article to help borrowers decide between lower payments on SAVE and faster forgiveness on PAYE.
As for who you can talk to, please send me an email and I’ll try to put you in touch with someone who can help.
You stated that if you make $30,000 per year and have $90,000 worth of student loans forgiven, the year the debt is forgiven; the IRS will tax you as though you earned $120,000.
If I am use to receiving a refund at the end of the year, by what you said up top, I will not receive that refund any longer until my debt is paid. Or, would that earned income of 120k/yr before the year it is forgiven and the next year I can again receive my refunds.
If its the first, is that really a forgiveness?????
I have a couple of thoughts here:
1) If you have a large amount of debt get forgiven in a particular year, you are likely to have a large tax bill when you file taxes for that particular year. Future refunds would not be impacted (unless you didn’t pay your previous tax bill and there was a garnishment situation)
2) The tax bomb for student loans is unlikely to happen to you. It doesn’t won’t happen to anyone until 2025, and there is a good chance that the policy become permanent. Preparing just in case is the smart route, but it hopefully never becomes an issue.
Thanks for this wonderful article! I am a self-employed acupuncturist with 2 FFEL loans held by NAVIENT. I’ve been paying on the IDR plan for the last 15 years, and have never missed a payment. But I’ll be looking at a huge tax bomb in another 11 years. (Also, I’ll be retired by then.)
I’d like to apply for Direct Consolidation in order to qualify for PSLF or other forgiveness program. Is this possible as a self-employed person (not a 501-C-3)? Thanks
Unfortunately, self-employed people can’t qualify for PSLF.
“One Mistake to Avoid
Some borrowers have suggested paying a little extra on their student loans to keep the balance low. By keeping the balance lower, these borrowers are trying to reduce the potential future tax bill.
The problem with this approach is that it would be a poor allocation of resources. Suppose that in the future, when the giant tax bill comes, the borrower is in the 25% income tax bracket.
By paying an extra $10,000 over the years, the borrower would reduce the eventual big tax bill by $250. In other words, by paying an extra dollar now, the goal would be to save 25 cents in the future”
In a 25% income bracket, you stated paying an extra $10,000 would only save you $250… Isn’t 25% of $10,000 equal to $2,500?
Thanks for catching that… you are absolutely right.
The point remains the same, which is to say that it doesn’t make sense to pay more now to save a fraction of that amount in the future, but that $250 will be corrected.
I appreciate you taking the time to comment to make sure things are as accurate as possible.
Whats everyone investing in to prepare for the tax bomb? I know people aren’t allowed to give financial advice unless qualified but interested in what people have chosen?
I was considering a simple S&P 500 tracker but am also wondering about a target date retirement fund. These get a bad press because actual date of retirement may vary but a tax bomb is due on a known date so seems like these would be perfect and avoid the need to have to manage a gradual switch over into less risky assets as the due date approaches. What haven’t I considered?
I personally think a target date fund would be smart. It does sound smart because it would be invested more aggressively in stocks early on and as you get closer to the target date be invested more conservatively.
My only opinion on these target date funds is to make sure to pick a low expense ratio one rather than an expensive actively managed one.