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December 18, 2012 3:04 PM The Looming Tax Bill on Loan Forgiveness

By Daniel Luzer

The income-based repayment (IBR) plan for federal student loans, which limits student loan payments to 10 percent of discretionary income for students who take out loans after July 1, 2014 and forgives the loans after 20 years, took effect on November 1, 2012. The plan offers many former and current college students a reasonably manageable student loan repayment schedule. But it’s not entirely painless for debt holders, however.

One aspect of the plan that hasn’t received much coverage, however, is that the loan “forgiveness” that occurs after 20 years doesn’t just represent a zeroing out of remaining debt. The federal government will treat the final payoff as income.

According to an article by Ron Lieber in the New York Times:

Those breathing a sigh of relief that their student loan payments are now in line with their income may want to re-examine the rules that set the payment in the first place. There could be a tax time bomb looming, slowly ticking away. And defusing it is not a big part of the policy discussion in Washington at the moment.
The catch comes with the forgiveness, since you generally have to pay income taxes on any forgiven debt (unless you were in a program for teachers or worked in a public service job, in which case the taxes go away). For many people, especially those who finished graduate or professional school with six figures of debt, the tax bill could be well into the five figures. And when it comes, you are supposed to pay in full, immediately.

That means that if you graduate with $170,000 worth of debt and you make good salary and provide payments on time every month, at the point when you get to pay off the remaining, say $83,482, you have to pay taxes on that $83,482, in addition to your normal income.

That’s not going to be very easy to do, and it’s also not something with which, at this point, people with great big debt loads are too concerned.

That being said, tax policy changes often; just because people are scheduled to pay huge income taxes in two decades doesn’t mean they actually will. If enough Americans object to the tax bill Congress might find a way out.

But it might not. For now it’s important merely to keep this in mind for policy discussions. Federal student loans are provided to students by taxpayers, through the federal government. The country can’t just lose money on this loan forgiveness program; it has to work out financially, at least in theory. How will the government attempt to balance its books when programs get expensive? The same way governments always try to balance budgets: taxes.

Daniel Luzer is the news editor at Governing Magazine and former web editor of the Washington Monthly. Find him on Twitter: @Daniel_Luzer