Obama Proposes Tax Free Student Loan Forgiveness

April 22, 2013

We reported last week that President Obama’s 2014 budget proposal included some boons for those dealing with student loan debt. We discussed his proposals on interest rates, expanding the Pell Grant program and capping the amount of household income that would go to student loans. Another critical aspect of Obama’s 2014 budget – and the focus of today’s blog – is his push for student loan forgiveness to be tax free!

What’s the big deal about forgiven loans being taxable?

Consider this scenario…

If you’ve been on an income based repayment plan paying your student loan payment each month for 25 years, as soon as you make the last of those payments, your remaining federal loan balance would be forgiven. Let’s say you initially owed $30,000, but with all of the interest and fees that have glommed on over the years, your balance skyrocketed to $85,000.

Trust us, it happens – this is what it known in the business world as an upcharge – because it’s not just interest that’s tacked on – it also includes fees of all types that are about as useful as a life preserver in the Sahara…

Your dutiful payments of $150 per month for 25 years would total $45,000. While this is well more than what you borrowed at the outset, it is far short of the total debt and left you owing a loan balance of $40,000. That amount would be forgiven. Sounds great, right? Not so much as you might think.

Say you earn $35,000 per year, for that year your income would shoot to $75,000! That would knock you out of many deductions you normally get, reduce or eliminate certain credits and drastically increase your tax liability. And there’s no withholding to offset the tax liability so that’s a big chunk of change that you’ll owe Uncle Sam as of April 15th after that 25th year. And that’s not even counting the additional sting of owing even more if you live in a state with state income tax.

If you think the example above is not typical, think again! The Office of Management and Budget calculated that a borrower who has an initial total debt of $39,500 will have $41,000 forgiven. This will have recipients of forgiveness paying an average of $10,000 more in income taxes for the year forgiveness is granted. 

How does a forgiven student loan become income?

Think of it this way. The forgiven amount is an amount you would have expected to pay, right? But now that you don’t have to pay it, it effectively frees up that amount of your disposable income. That’s called imputed income and is taxable.

It’s not just forgiven student loan debt that’s taxable. In many cases, any type of debt that’s cancelled in part or in full will be taxable. For example, say you owe $3,000 on your credit card and you can’t pay it. The creditor negotiates a settlement with you and accepts a lump sum payment of $1,000 to clear the debt. The other $2,000 is considered income. You may receive a Form 1099-C and will have to claim this amount on your income tax return.

Student loans forgiven under Public Student Loan Forgiveness or Teacher Loan Cancellation plans are not taxable. And if President Obama gets his way, the income tax burden would be eliminated for all student loan borrowers whose debts are forgiven. This would be a truly meaningful outcome for those struggling with student loan debt. Of course, POTUS proposing it doesn’t mean that Congress will adopt it – but we can hope!

Lauren Asher, President of The Institute for College Access & Success (TICAS), says, “Currently, concern about whether forgiven debt will be taxed in the future may discourage those who need help under income-linked repayment plans from participating.” TICAS promotes affordable education and oversees the Project on Student Debt which is dedicated to making college more affordable and available to people of all backgrounds.

If you have student loans – no matter what stage of your education you’re in or how far or near you are to repayment – try Tuition.io’s free student loan tool to manage your loans in one easy to use interface. You can explore repayment options including those which qualify for forgiveness.

Enjoy these other recent blogs of ours on the President’s budget and education initiatives and student loan forgiveness programs:

Obama’s Student Loan Proposal – Pros and Cons

3 Missteps That Could Cost You Your Student Loan Forgiveness

4 Student Loan Forgiveness Programs for Teachers

Top 5 Programs to Help Pay Off School Loans

Who Else Wants Tax Free Student Loan Forgiveness?