Student loan forgiveness sounds like a dream come true for countless borrowers who feel weighed down by debt, but forgiveness programs can result in a hefty tax bill you’re not prepared to pay. In fact, following student loan forgiveness, you could owe thousands to the Internal Revenue Service (IRS) due to a forgiveness tax that essentially views your forgiven debt as part of your annual income.
The Dreaded Tax Burden
Since the amount of student loan debt forgiven must be claimed as taxable income, you could be placed in a different tax bracket during the year in which your debt is forgiven. Instead of owing your student loan servicer, you now owe the government, which has less flexible rules where repayment is concerned. In other words, you owe that taxable amount up-front and out of pocket when taxes are due, and although you can set up a payment plan with the IRS, there’s very little wiggle room.
When your tax payment on forgiven debt comes due, you may have to seek other monetary sources to cover your tax bill. This can mean borrowing against your life insurance or retirement account or taking out a private loan. Depending on how much debt is forgiven, you could come out financially on top, or you could be stuck with yet another monthly payment that doesn’t come with the same repayment perks as the original student loans.
When you enter into an income-based repayment plan with the intention of having your debt forgiven in 20 to 25 years, there’s a good chance you’ll end up paying more money in interest than on the actual principal amount. Essentially, you’re paying more interest over the life of the loan without any of that money going to the principal, and your forgiven debt will be close to the original loan amount.
As we’ve already explored, the more money is forgiven with a student loan forgiveness program, the more tax you will owe. A better option is to pay as much as you can each month, even doubling your student loan payments until the forgiveness program kicks in. This way, you’ll have paid less on interest and more on the principal amount, which will mean you’ll be taxed on a lesser loan amount.
While income-based forgiveness programs are a popular option, so is the Public Service Loan Forgiveness Program. This program allows you to enter a public service career, work for a certain number of years, and have your student debt forgiven.
The problem with this type of program is that you may find yourself having difficulties landing the right career and sticking with it. There are student debt forgiveness programs for teachers, nonprofit employees, lawyers, doctors, and social workers, but what if you get a job in the right field and need to leave before your time in the program is up? You end up losing your ability to have your loans forgiven. What’s more, many people who enter the program just to have their loans forgiven end up dissatisfied with their careers and struggle to stay put until the end of the forgiveness term.
Then there are also fears surrounding the longevity of the Public Service Loan Forgiveness program itself. The Department of Education has allegedly changed its position on whether certain employers qualify for the program when it had previously stated these employers did qualify. In other words, you may enter a career-based forgiveness program now with the promise that your loans will be forgiven after 120 qualifying payments, but the rules can change before then, leaving you with nothing to show for your years of service.
Did you know that 46 states extend student loan repayment assistance options to residents? In general, these programs only pay a portion of your student loan and require you to work in a specific field in order to qualify, but they can be great options when you’re trying to figure out how to reduce your debt.
There is a catch, however. State-based forgiveness programs require you to live in that state for a certain amount of time. In some cases, they may even require you to live in a certain area of the state. This means not having the freedom to move if you’re offered a new job or simply want a change of scenery.
Many of these state-based programs are offered to public-service fields such as dentistry, health care, legal, and similar careers. Before assuming you can rely on this type of program, research what options are available in your state and how you can qualify.
In addition to career-based forgiveness programs, you can also eliminate some or all of your student debt by making a big life commitment. Joining the military, for example, comes with Public Service Loan Forgiveness benefits, but you must join a branch of the military and fulfill your duties.
Volunteering is also a good way to qualify for debt forgiveness, but not just any kind of volunteer work will do. If you commit a portion of your life to the Peace Corps, you can enjoy an automatic deferment on federal student loans and a partial cancellation based on your years of service. At the time of this writing, the Peace Corps will cancel 15 percent of your debt per year, not to exceed 70 percent.
Americorps and Volunteers in Service to America (VISTA) are two more options. If you serve one year in Americorps, you can receive $4,725 to put toward your loan debt. With VISTA, you receive the same amount as long as you volunteer for 1,700 hours. While these options sound intriguing, it’s important not to make any long-term volunteer decisions lightly.
Student loan forgiveness programs are beneficial to many Americans, but they do have their drawbacks. Weigh your options carefully before deciding if a forgiveness program is right for you, and make plans to take care of any additional burdens that can come along with that decision.