The good news for borrowers? An estimated 43 million Americans with student loan debt will have $10,000 wiped away from their balances.
The even better news? The debt relief is tax-free.
As President Joe Biden announces the historic step that borrowers with federal student loan debt will have $10,000 wiped away from their balances, recipients of the loan forgiveness will not have to worry about paying federal income tax, thanks to a provision in the American Rescue Plan (ARP) of 2021.
The COVID-19 relief package, which became law in 2021, designates federal student loan forgiveness as tax-free through the end of 2025.
Typically, some loan forgiveness programs are considered taxable income in the year the debt is written off. This includes loan discharges for closed schools, false certification, and death and disability of the graduate.
Additionally, when a graduate completes the required monthly payments under income-contingent and income-based repayment plans, the remaining balance that is forgiven is considered taxable income. Many recipients have been caught by surprise by their larger-than-normal tax bills.
Other forgiveness programs are never taxable, including Public Service Loan Forgiveness, teacher or law school loan repayment programs, or the National Health Service Corps program.
But the ARP changed that for debt forgiven from December 31, 2020, through January 1, 2026. It covers all student loans originated by the government and private lenders, including federal and private student loans, federal and private parent loans, and loans from a college or university, among others.
Here’s an example of what you might owe the IRS without the tax break. The average starting salary for a college graduate is approximately $55,260, placing them in the 22% federal income tax bracket in 2022, assuming they are a single tax filer. If a loan amount of $10,000 is discharged, the borrower would owe $2,200 when they file their 2022 income taxes.
For borrowers on the cusp of two tax brackets, the loan discharge amount could push them into the higher bracket, potentially increasing their overall tax bill.
That said, it is not yet clear whether or not some borrowers would owe state income tax, depending on where they live.
The tax break bodes well for borrowers, as the average student loan monthly payment is $393 per month. Without a tax break, they would have to pay over five and a half months worth of student loan payments to the IRS. And if this price wasn’t already overwhelming, the IRS charges interest on unpaid taxes and enforces a failure-to-pay penalty of 0.25% of the amount owed while a payment plan is in effect.
This is a developing story. Check back later for more details.
How will student loan forgiveness affect you and your finances? Please email reporter Alicia Adamczyk to be featured in a future article.