Depending on where they live, student borrowers may soon face an unexpected tax burden.
In August, the Biden Administration made news by announcing that it would forgive up to $10,000 in student debt for most borrowers and up to $20,000 for Pell Grant recipients. This would eliminate student debt entirely for approximately 20 million borrowers, primarily among low-income households, and would reduce the average bachelor’s degree debt by about one-third.
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But the government giveth, and the government taketh away: Some states have announced that they will tax this loan forgiveness as a form of income. Here’s how to determine if you’ll face a tax bill on your student loan forgiveness.
For extra assistance navigating the complicated terrain of taxes and student loan forgiveness, consider matching with a trusted financial advisor.
Which states tax student loan forgiveness?
Mississippi, North Carolina and Indiana have confirmed that they will consider the Biden student loan forgiveness program a form of taxable income, meaning that borrowers will have to report it on their annual income taxes for the year in which the debt is formally discharged. Several other states have confirmed that they are considering this as well, or are waiting to see the final details of the Biden proposal.
The federal government will not tax Biden’s loan forgiveness proposal, because the American Rescue Plan suspended taxes on student debt forgiveness through 2025. The details of this hinge on how state and federal tax collectors treat debt forgiveness. While not commonly known among students and graduates, under ordinary circumstances the IRS and state tax agencies treat student debt forgiveness as any other form of debt discharge. This means that they consider it effectively income for the year in question. For example, say that you owe $10,000 and your lender officially waives the debt. For tax purposes, you will have been enriched by $10,000 and must report it as additional income. Absent any other circumstances, student debt is treated no differently.
This can lead to a significant, and often unexpected, tax bill at the end of the year. With the average worker paying about 13% of income in taxes, $10,000 worth of student loans forgiveness will increase the average graduate’s taxes by $1,300. Since this wasn’t reflected in the person’s wages, it will not have been automatically deducted on the person’s W-2 over the course of the year. Instead the taxpayer must make up the difference by paying any additional taxes when filing.
This comes up most often for borrowers who take advantage of income-based repayment. This program limits a borrower’s payments based on personal income and, after 25 years, forgives the remaining debt entirely. Those borrowers then owe taxes on the entire amount discharged. For some workers this can increase their taxable income by more than they earned in the entire year.
On occasion the government will carve out exceptions to this rule. For example, students who receive debt forgiveness based on public or military service do not have to report it as income. This is what happened under the American Rescue Plan, when the government created a blanket carve-out for all loans forgiven between 2021 and 2026. However that only applies to the federal government. States are free to treat this debt forgiveness as they see fit.
Uncertainty around taxes on student loan forgiveness
Many states have passed laws adopting the American Rescue Plan’s tax suspension. Others already treat student loans differently from the IRS, or in some cases have no income tax at all. Borrowers in those states will face no tax event from the Biden loan forgiveness proposal.
In other states, however, this can have significant consequences.
While only three states have confirmed that they will collect taxes on the Biden loan forgiveness plan, an analysis by the Tax Foundation suggests that several others might do so under existing law. Most notably Arkansas, Minnesota and Wisconsin have laws that appear to treat this loan forgiveness as taxable income, although the states have issued no formal guidance as of yet. Massachusetts has announced that it does not anticipate taxing this debt forgiveness, although confirmation will depend on the final details of the program.
Other states, however, have become more complicated.
Read the full article here by Eric Reed of SmartAsset, Advisor Perspectives.
