Jumping out of the fire and into the frying pan is an apt description for borrowers who face a large tax bill after finally obtaining student loan forgiveness. Experts commonly refer to this bill as the “student loan tax bomb.”
The good news is that this daunting tax bill is often avoidable.
Unfortunately, not every borrower will be able to sidestep the student loan tax bomb. It remains a significant drawback of pursuing loan forgiveness and is an important factor for any borrower considering this option. Thus, it’s crucial to understand the potential financial impact of this tax liability and plan accordingly.
Student Loan Tax Bomb Origins
The student loan tax bomb originates from a specific tax rule that requires forgiven debt to be taxed as income in the year it was forgiven.
This rule often makes sense in various contexts. For example, if you work for Visa and Visa forgives some of your credit card debt as a bonus, it’s reasonable to tax that forgiven debt as income. This prevents companies from exploiting loopholes by issuing “loans” to employees and then “forgiving” them as a way to avoid paying taxes.
Treating forgiven student loans as taxable income follows the same logic, ensuring fairness in the tax system. Regrettably, the tax bomb creates a financial challenge for the student loan borrowers receiving the forgiveness. Student loan borrowers should, therefore, prepare themselves to overcome that hurdle.
Student Loan Forgiveness Isn’t Taxed – For Now
Currently, 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 excluding most forgiven student loan debt from taxable income will expire. At that point, the student loan tax bomb will be in play again.
While 2026 may seem distant, it’s important to note that many borrowers do not expect to earn forgiveness until after this date. Therefore, it is crucial to prepare 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. This approach allows me to save money in a tax-advantaged account. If I end up with a tax bill, I’ll have the funds set aside and ready to go. If I get lucky and Congress passes more legislation that exempts my debt forgiveness from taxable income, I will have saved extra money for retirement.
For those looking for a simpler option, a high-yield savings account can also be a good strategy. Any money saved for a potential tax bill can earn a decent return, growing over time.
The Rules on Debt Cancellation Should Change
Student loans have indeed become a politically charged topic. Yet, there appears to be bipartisan agreement on certain aspects, such as the taxation of loan forgiveness. The temporary rule that prevents the taxation of forgiven loans until 2026 wouldn’t have passed without support from both parties.
One compelling argument against taxing forgiven debt comes from parents with Parent PLUS loans. Under the rules for these loans, if the child for whom the loan was taken out passes away, the remaining debt is forgiven. However, prior to the change in tax rules, these parents faced substantial tax bills on the forgiven amounts—an outcome that was both tragic and widely regarded as unfair.
While predicting political outcomes is inherently challenging, the bipartisan support for the temporary tax relief measure suggests a growing recognition of the unfair burden placed on individuals in already difficult situations. Given this, there’s reason to hope that Congress might eventually eliminate the tax on forgiven student loans permanently, offering significant relief to borrowers.
How to Calculate Your Student Loan Forgiveness Tax Bill
Projecting a potential student loan forgiveness tax bill is tricky business. There are a number of uncertainties that make accurate forecasting difficult.
For starters, we don’t even know if this tax will exist by the time many borrowers qualify for forgiveness. Even if we prepare for the worst-case scenario in which the tax remains in place, predicting future personal income levels and tax brackets is nearly impossible.
In 2023, tax rates ranged from 10% to 37%. To illustrate what this means, here is an example. If you received $1,000 in forgiveness in 2030, and the tax rates remained the same, this would result in adding between $100 and $370 to your tax bill. The borrowers with the largest loan balances could be looking at tax bills of over $200,000!
State Taxes on Federal Loan Forgiveness
Federal taxes aren’t the only issue that borrowers need to consider when planning for the financial impact of loan forgiveness. State taxes may also play a role in the overall financial effects of loan forgiveness.
Many states align their tax policies with the IRS regarding loan forgiveness. In these states, there is no tax — at least until the federal exemption expires in 2026. At that point, these states may tax forgiven debt unless the legislature makes further changes.
Some states have their own rules for determining taxable income and do not follow IRS guidelines for forgiven debts. Some of them currently do tax forgiven debt while other states are considering following suit. For example, in 2023, Indiana, North Carolina, and Mississippi included student loan forgiveness as taxable income. Thus, even if Congress permanently excluded this income from tax, your state could still have different ideas about its taxability.
Because of these varying state tax implications, some borrowers who qualify for student loan forgiveness may find themselves in a position where accepting the forgiveness isn’t financially beneficial. In extreme cases, the tax bill could be so high that opting out of forgiveness becomes the more viable option. Borrowers should carefully assess their individual tax situations—considering both federal and state implications—to make the most informed decision about pursuing student loan forgiveness.
Tax Rules to Avoid the Massive Bill
As previously mentioned, the general rule is that forgiven debt is taxable income unless Congress has specifically excluded it. The IRS provides some additional reasons why taxpayers can still exclude forgiven debt from taxable income. The main exclusion that might be helpful to student loan borrowers is regarding insolvency.
In essence, the rule is that the taxpayer can exclude forgiven debt to the extent that the taxpayer was insolvent immediately before the forgiveness. What this means is that if the taxpayer’s total liabilities exceeded their total assets at the time of forgiveness, the taxpayer can exclude some or all of the forgiven debt from taxable income.
Some states may offer a similar exemption. However, the rules can vary widely, and not all states align with federal rules on this matter.
For those considering this as part of their financial strategy, it’s essential to approach with caution. Planning for the worst while hoping for the best is advisable. Don’t assume you can avoid the tax via the insolvency exception until you get the green light from an accountant. This careful approach ensures that you’re fully prepared for any tax implications that may arise and can plan accordingly.
The IRS provides Low Income Tax Clinics for those who qualify.
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 harsher the tax consequences can be.
For borrowers who have substantial balances and are making lower monthly payments under an IDR plan, their balance might actually be increasing each month if their payments don’t cover all of the accruing interest.
In this circumstance, the new SAVE plan offers an excellent option to keep down the tax bill. On the SAVE plan, borrowers receive a generous subsidy that helps prevent the loan balance from growing.
This is particularly advantageous for those who qualify for $0 per month payments. They have an effective interest rate of 0% on the SAVE plan.
By keeping the balance stable or even reducing it, the SAVE plan helps ensure that when borrowers eventually qualify for forgiveness, the total amount forgiven—and consequently, the potential tax bill—will be more manageable.
All IDR borrowers should investigate the new SAVE plan, estimate potential monthly payments, and sign up when appropriate.
Another issue that affects anyone who pays for Medicare B and Medicare D is that your premiums. Social security figures those amounts based on your income 2 years ago. As a result you will need to fill out a form to show a change of circumstances (I will have 99K discharged, paid 102K).
Below I copied from a handout I created about discharge due to disability using a physicians letter (you can have a copy for free to use if you’d like just let me know where to send it; a higher level supervisor gave me some of the information I included in there including stupid reasons why they reject you – for example anything written outside of the tiny boxes, they won’t read attached letters so if you reason is in that, etc. although you can re-apply immediately unlike SSD rejections where you need a hearing).
Medicare premiums: Your Medicare B and D premiums depend on what your tax return from two years prior states your income was. If your student loans were formally and permanently discharged in, for example, 2027 and you received a 1099-C that year then in 2029 your Medicare premiums would go up if you moved into a higher income group. Of course now, in 2029, your income would be lower because the change in your “ordinary income” was due to student loan forgiveness and not actual ongoing income.
You have two different forms you need to look at to decide which best fits your circumstances to appeal the higher Medicare Premiums to get them adjusted. If your circumstances don’t fit what is on Social Security Form SSA-44 you can file Form SSA-561-U2, Request for Reconsideration. See the websites for the two different forms and the income dependent premium amounts.
https://www.ssa.gov/forms/ssa-44.pdf
https://www.ssa.gov/forms/ssa-561-u2.pdf
Also, of course, a tax payer could file for insolvency which may or may not solve the issue depending on what the IRS laws are at the time of the discharge.
Also do you know if there are any plans, any federal congress person working on a law, etc. to reintroduce a law to exempt those who had their loans discharged through disability (separately from the other “loaded” issue of anyone at the end of 20 or 25 years of pyament)?
I know if a disability discharge was done by way of a VA disability discharge you are not liable for taxes on the discharged amount, but if you get the discharge via social security or physician’s letter (starting 1/1/26 since that law ends the pause and there needs to be another law to address this, the IRS needs a law, not administrative action and is free to ignore court orders as has happened in the past over this exact issue) and aren’t done with your 3 year monitoring by 12/31/25, then this is taxable income. My tax (in my case both state and federal) will be about $32K which is far more than I get a year in income.
Thanks
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.