What Should Student Loan Borrowers Know?

The Senate on Saturday approved President Biden’s huge $ 1.9 trillion stimulus package. The legislation includes a small but important amendment to the student loan law that could have significant impacts on student loan borrowers who are repaying their loans under income-based repayment plans.

Specifically, a provision of stimulus legislation temporarily exempts the forgiveness of student loans from federal taxation. This has important implications for student loan borrowers hoping to obtain student loan forgiveness through income-based repayment plans, such as income-based repayment (IBR), contained income repayment (ICR), Pay As You Earn (PAYE) and Earn Payment Review (REPAY).

Income-based repayment for student loans

Income-based repayment programs are a lifeline for millions of federal student loan borrowers. The term “income amortization” describes a collection of plans that calculate a borrower’s monthly student loan payment based on their income. These plans include income-based amortization (IBR), contingent income refund (ICR), earnings payment (PAYE) and revised earnings payment (REPAYE).

While each plan is different, they all work similarly on a basic level. Monthly payments under income-based plans use a formula based on the borrower’s family size and taxable income (usually your Adjusted Gross Income (AGI) as reported on your federal tax return) . Payments are recalculated every 12 months, so as the borrower’s income changes, so would their payments. It is important to note that any remaining balance would be forgiven at the end of the plan’s repayment 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 major catch.

Forgiveness of the student loan in the case of amortization motivated by income

In addition to affordable payments, income-based plans such as IBR, ICR, PAYE, and REPAYE provide for forgiveness of the borrower’s federal student loans at the end of their repayment programs. This is important, because many student loan borrowers could never fully repay their student loans.

But traditionally, this type of student loan forgiveness is considered a taxable event. In other words, the balance forgiven at the end of the loan repayment period could be treated as “income” for the student loan borrower for tax purposes. This has major ramifications, especially for borrowers whose payments according to an income-based return plan are not high enough to cover accrual of interest, which can lead to an increase in the balance, even while the payments are being made. payments.

Here you have an example. We take a single borrower who has a federal student loan balance of $ 60,000 at an interest rate of 6%. Suppose you have a current and projected annual taxable income of about $ 35,000 a year (for simplicity, we will not assume significant changes in your income over time). Your monthly payment under the Income-Based Return Plan (IBR) would be around $ 210 a month (compared to a normal ten-year standard plan payment of about $ 660 a month).

This monthly IBR payment is affordable for the borrower. But interest on the balance accrues to $ 300 a month. Thus, even while the borrower makes payments of $ 210 per month, the difference ($ 90 per month) accumulates in interest. As a result, the student loan balance of the borrower actually grows up with the pass of time. After 25 years, that $ 60,000 balance would be $ 87,000, even though the borrower 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, but will end up getting an even higher balance than he started.

Adding insults to injury, if that $ 87,000 balance is forgiven and taxed as income, the student loan borrower could look at a massive tax bill. Assuming an effective tax rate of 25%, you may have to pay income taxes in excess of $ 21,000 for the year your student loans are forgiven. And that should be all of a sudden, right away.

Student loan forgiveness tax is eliminated – Temporarily

The provision of student loan taxes in the Senate Stimulus Bill exempts student loan forgiveness from federal taxation. This would cover a multitude of student debt cancellation events, including student loans forgiven in income-based repayment plans. This could eliminate the threat of the so-called “tax bomb” (as some call it) at the end of the loan repayment terms when the borrower’s student loans will be forgiven. State tax treatment of student debt cancellation may vary.

However, due to the way Democrats had to pass the stimulus bill in Congress (through the budget conciliation process, given the large Republican opposition), the tax cut is only temporary and is currently scheduled to expire. ‘January 1, 2026.

Relatively few student loan borrowers are expected to get their loans under these programs by then, as most income-based repayment plans are under 25 years old. The ICR plan, however, was created in 1994, so there will be some borrowers who pay off their student loans under ICR (or who started with ICR and later switched to IBR or REPAYE) who in fact their 2026 loans will be forgiven.

That said, this tax cut on student loans is a critical first step. It 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 expand this tax cut or make it permanent, as more borrowers will be eligible for student loan forgiveness under these programs in the coming years. Failure to act in 2026 would effectively result in a tax to increase in millions of student loan borrowers, which would be a bipartisan political landmine.

What’s next?

The bill is now back in the House for a final vote, which could arrive as early as Tuesday. President Biden is expected to sign the bill in a week.

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