“student Loans And Tax Implications: What Borrowers Need To Consider” – The Save America plan recently passed by Congress makes student loan forgiveness tax-free for the next five years. This removes from the student loan forgiveness debate the inconvenient fact that canceled debt is generally considered income and therefore subject to income tax. Our analysis shows that in the absence of such provisions, forgiveness could hurt many borrowers in the short term, taxing them with large and unexpected bills, even if it would be a good deal in the long run.
To understand the implications of tax-free forgiveness, we examine two of the most popular forgiveness proposals – President Biden’s proposal to forgive up to $10,000 of federal student loan debt per borrower (“the 10K plan”) and Senators Schumer and Warren’s proposal of up to $50,000 ( 50K plan) to be given. How much did different types of borrowers owe in additional federal taxes under each of these plans?
“student Loans And Tax Implications: What Borrowers Need To Consider”
The answer to this question depends on two main factors: how much debt the household has forgiven and its income. Our progressive tax system means that higher-income households pay more tax on forgiven debt, and a larger amount of forgiveness can push a household into a higher tax bracket. Many low-income households pay no federal income taxes, and some receive refunds such as the Earned Income Tax Credit (EITC).
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As shown in the figure below, borrowers who earn at least $122,000, which is about 20 percent of borrowers, will owe the most additional tax – $2,400 under the 10K plan and $6,160 under the 50K plan. Those earning less than $25,000 — about 12 percent of borrowers — would owe $800 and $1,893, respectively.
Under the 10K plan, most households receive the full $10,000, so the difference in taxes owed is mostly due to progressive taxation. Under the 50K plan, higher-income borrowers receive more forgiveness (and therefore more taxable income) than lower-income borrowers because they owe more (an average of $25,200 for the highest quintile and $16,000 for the lowest).
Borrower surcharges can be overwhelming for many low-income borrowers. Consider the average borrower in the second income quintile, who makes between $25,000 and $43,000 a year. Under the 10K plan, she would face an additional federal income tax burden of $1,200. Under the 50K plan, this borrower would be forgiven about $4,200 in additional federal income taxes for a total of $25,760. For perspective, nearly half of borrowers in this income quintile cannot cover their 10K loan with money in their checking and savings accounts.
We also consider the potential tax burden of debt forgiveness by calculating it as a share of income. For more than three-fifths of borrowers in the lowest income quintile, their additional tax burden under the 10K plan is more than 5 percent of their income, and nearly one-fifth are more than 10 percent.
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For low-income households receiving the EITC, the impact could be particularly severe. About 14 percent of households with student loans pay negative income taxes, primarily because of the EITC. Many of these households plan their spending around that extra income, but more than 90 percent see their refunds shrink, and more than a quarter end up owing back taxes, not a check. This sudden loss of income occurs suddenly and without choice—unlike an additional tax liability that is voluntarily spread out through a distribution plan (albeit with interest).
Under the 50K plan, the share of borrowers paying more than 5 or 10 percent of their income in additional taxes increases to 70 percent and 60 percent, respectively, with borrowers in the second quintile facing an even greater burden than those in the first quintile. faced (probably because many households with very low incomes are exempt from federal income tax).
We do not find significant differences in additional tax liability by race. About 15 percent of black and white borrowers will owe at least 10 percent of their income under the 10K plan. We see some differences within the 50K plan: Black borrowers face the highest additional taxes as a share of income, with more than 60 percent making at least 5 percent of their income and nearly half making at least 10 percent (compared to 55 percent). and 21 percent of white households). This is because the average student loan debt among black borrowers ($29,000) is higher than that of white borrowers ($22,500), a result of structural factors such as racial wealth differences and labor market discrimination.
Our analysis shows that the risk of turning an education loan into a tax debt is high for many low-income borrowers, especially if the forgiveness amount is large. America’s bailout plan ensures that any debt forgiveness plan enacted in the near future will not result in unexpectedly large bills, especially for low-income borrowers. Before the provision expires in 2026, Congress must consider whether to make it permanent for all borrowers or target it in some way, such as limiting the amount of tax that is calculated based on a borrower’s income.
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Methodology Notes: We use the National Bureau of Economic Research’s TAXSIM program and the 2019 Survey of Consumer Finances (using 2018 income data) to estimate changes in federal income taxes for each amnesty scenario. For simplicity, we only count federal liability, although households may also owe state taxes. We treat forgiveness as “other income” for tax purposes. For simplicity, all non-taxable income is treated as wage income. We use “borrower” as shorthand for “household with student loans,” and some households may have two borrowers. The forgiveness plans we simulate offer up to $10,000 or $50,000 per borrower in a household. We first forgive borrowers of their own education debt, and if they also have debt for the education of their children or other relatives, we forgive it up to a maximum of $20,000 or $100,000. Student loan debt reached $1.34. trillion in the first quarter of 2017, up from $0.51 trillion 10 years ago. The consequences and benefits of taking out student loans go beyond career opportunities, lifetime income, and other consequences; like most things, it ends up on the tax return. Here’s the potential impact of student loans on a student’s tax situation.
When students start paying off their student loans, they can start deducting interest — even if they don’t itemize their deductions. The $2,500 maximum deduction is “above the line,” which means they don’t have to file a more complicated tax form to claim the benefit. This is a tax return limitation, so a married couple who both pay off student loans cannot deduct more than $2,500 each year on their joint return.
Taxpayers can deduct student loan interest earned on loans taken out for themselves, their spouse, or dependents. For example, parents can keep the interest on the loan taken for their child’s education expenses. But parents cannot pay their child’s debt and take the deduction. In the event that the student receives a loan but the parent repays the loan, the parent is treated as a gift to the student and the student is treated as paying off the loan.
Some employers offer student loan forgiveness as an employment benefit. Typically, the IRS considers a forgiven debt to be income that the taxpayer must report and potentially pay taxes on. However, if student loan forgiveness is part of a program to attract students to certain careers or areas of unmet need, the forgiveness may be tax-free.
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Other employers may offer refundable benefits. The amount the employer pays toward the employee’s student loan is taxable income to the employee. While an employee’s tax liability may increase due to the payments, the employee may be able to partially offset this by deducting the interest on their student loan.
Unfortunately, not all student loan forgiveness situations are positive. After recent school closings across the country, students may be owed student loans for a school that can’t award them a degree or certificate and can’t transfer their credits.
In this scenario, students who have federal loans can apply to pay off their closed school loans. The amount donated is generally not taxable. Not all students and not all loans meet the eligibility criteria, and students (or their parents) should investigate other options for student loans.
Other loans, such as those that cover living expenses, are still forgiven. However, students may owe income tax on the amount of the forgiven loan. In this case, they will receive a tax slip in the mail that reports the amount as income and can include it on their tax return.
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Even if they receive a tax return on their loan forgiveness, students may still be able to exclude this income from their tax return if they can show that they are not bankrupt or qualify for another exemption.
If a student is in default of their federal
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