What student loan borrowers should know

The Senate on Saturday approved President Biden’s massive $ 1.9 trillion stimulus package. Included in the legislation is a small but important adjustment to the student loan law that can have significant impacts on student loan borrowers who are paying their loans under income-based repayment plans.

Specifically, a provision of the stimulus legislation temporarily exempts forgiveness of the student loan from federal taxes. This has important implications for student loan borrowers who hope to obtain student loan forgiveness through income-based repayment plans, such as Income-Based Repayment (IBR), Contingent Income Repayment (ICR), Pay As You Go (PAYE) ) and Pay As Revised You win (REPAYE).

Income-based repayment for student loans

Revenue-based repayment programs are a lifeline for millions of federal student borrowers. The term “income-based repayment” describes a collection of plans that calculate a borrower’s monthly student loan payment based on their income. These plans include Income-Based Reimbursement (IBR), Contingent Income Reimbursement (ICR), Pay As You Win (PAYE) and Pay As You Earn Revised (REPAYE).

Although each plan is different, they all work similarly at a basic level. Monthly payments on income-based plans use a formula based on the borrower’s family size and taxable income (usually their adjusted gross income (AGI) as reported in their federal income tax return). Payments are recalculated every 12 months, so that as the borrower’s income changes, so do their payments. It is important to note that any remaining balance would be forgiven at the end of the plan’s amortization period, which is 20 or 25 years, depending on the specific program.

For millions of borrowers, an income-based repayment plan is the only affordable repayment option. But it comes with a significant catch.

Student loan forgiveness under income-based repayment

In addition to affordable payments, income-based plans such as IBR, ICR, PAYE and REPAYE offer forgiveness of the borrower’s federal student loans at the end of their repayment programs. This is important because many student loan borrowers would never be able to repay their student loans in full otherwise.

But traditionally, this type of student loan forgiveness is treated as a taxable event. In other words, the balance that is forgiven at the end of the loan repayment term can be treated as “revenue” for the student loan taker for tax purposes. This has important ramifications – particularly for borrowers whose payments under an income-based repayment plan are not high enough to cover the accrued interest, which can result in the balance growing, even while payments are made.

Here is an example. Let’s consider a single borrower who has a federal student loan balance of $ 60,000 at an interest rate of 6%. Let’s say she has a current and projected annual taxable income of around $ 35,000 a year (for simplicity, we will not assume major changes in her income over time). Your monthly payment under the Income-Based Reimbursement (IBR) plan would be around $ 210 per month (compared to a standard 10-year standard plan payment of around $ 660 per month).

This monthly IBR payment is accessible to the borrower. But interest on the balance is $ 300 a month. Therefore, even if the borrower makes payments of $ 210 per month, the difference – $ 90 per month – accrues interest. As a result, the borrower’s student loan balance actually grow up extra hour. After 25 years, that balance of $ 60,000 would be $ 87,000 instead, although the borrower has made $ 63,000 in total payments. Yes, you read that right – the borrower would have made enough payments to pay more than the original principal in full, but it ends up with an even greater balance than the initial one.

To make matters worse, if that $ 87,000 balance is forgiven and taxed as income, the student loan taker may be facing a huge tax bill. Assuming an effective rate of 25%, she may have to pay income tax of more than $ 21,000 in the year her student loans are forgiven. And that would be due at once, immediately.

The student loan forgiveness tax is removed – temporarily

The student loan tax provision in the Senate stimulus bill exempts pardoning student loans from federal taxes. This would cover a plethora of student debt cancellation events, including student loans forgiven under income-based repayment plans. This could remove the threat of the so-called “tax bomb” (as some call it) at the end of the loan’s repayment terms, when the borrower’s student loans would be forgiven. State tax treatment for student debt cancellation may vary.

However, due to the way in which the stimulus bill had to be approved by Democrats in Congress (through the budgetary reconciliation process, due to widespread Republican opposition), the tax reduction is only temporary and is currently scheduled to expire on 1st January 2026.

Relatively few student loan borrowers are expected to have their loans forgiven under these programs between now and then, since most income-based repayment plans are less than 25 years old. The ICR plan, however, was created in 1994, so there will be some borrowers who are paying off their student loans under ICR (or who started with ICR and later changed to IBR or REPAYE) who will actually have their loans forgiven before 2026.

That said, this reduction in the student loan tax is a critical first step. This will provide real relief to some student loan borrowers over the next few years. In addition, it will put enormous pressure on Congress and the White House to extend this tax cut or make it permanent, as more borrowers become eligible for student loan forgiveness under these programs in the coming years. Failure to act by 2026 would effectively result in a tax increase in millions of student loan takers – what would be a bipartisan political landmine.

What is the next?

The bill now returns to the House for a final vote, which could take place as early as Tuesday. President Biden is expected to sign the bill within a week.

Further Reading

Senate approves stimulus bill to reduce taxes on student loans – will it “pave the way” to cancel student debts?

Here’s everyone who wants Biden to cancel student loan debts (it’s a big list)

17 state attorney generals pressure Biden to cancel $ 50,000 in student loans, contributing to the pressure campaign

Whether Biden will cancel the student’s debt will depend on these three things

Biden: I support the cancellation of $ 10,000 in student debt and the “elimination of interest”

Biden wins $ 50,000 in student loan forgiveness – but supports this figure instead

Could these student loan borrowers be excluded from Biden’s forgiveness?

Can Biden cancel private student loans? 3 options