Student Loan Forgiveness Tax Consequences
One benefit that many students take advantage of is student loan forgiveness. However, loan balance forgiveness is not as straightforward as you may initially think. When a lender forgives your student loan, the IRS puts down the forgiven loan as income, which is then taxable in most cases. If your situation qualifies you for Public Service Loan Forgiveness or an alternative Loan Repayment Assistance Program, then you can rest assured knowing that these types of programs are tax-free. Unfortunately, anyone else who attempts to gain forgiveness from a PAYE or IBR will have to deal with his or her forgiveness being taxable. Luckily, there are some ways of minimizing your tax impact from student loan forgiveness.
The Impact of Taxable Loan Forgiveness
No matter the size of your student loan, if you qualify for PAYE or IBR and have been actively participating than the balance of your loan will automatically be forgiven. That amount is then written off and will be treated as income on your tax revenue in the same year. This indicates that if you made $60,000 in a year from your adjusted gross income, and your loan forgiveness was $20,000, your taxable basis will be $80,000. This means that instead of owing money on your student loans, you’ll instead owe money to the IRS. Unfortunately, they tend to be more powerful than student loan debt collectors, and they are not as patient in receiving the repayments.
How to Minimize Your Tax Impact on Your Student Loan Balance
The most important thing is to maintain your loan balance to a manageable amount that you can keep under control so that you can minimize the total amount that needs to be written off. You may have to let the student loan debt accumulate so that you can maximize the amount that can be forgiven. However, always keep in mind that this will maximize your tax impact during the year that your student loan is forgiven. For instance, if you borrowed $30,000 in student loans, it is entirely possible that this principal can grow to over $100,0000 and the higher your student loan balance, the more you’ll take a hit on your taxes.
Minimize Your Tax Impact to Avoid Interest
The worst thing that can happen to your student loans is interest capitalization. This essentially is compound interest in which interest is charged for interest. This can cause problems even if you are on PAYE or IBR, as the payments that you qualify for will likely be less than the interest that accumulates every month. If you only pay for this amount than your interest that isn’t covered will accumulate and thus be capitalized. Capitalization occurs when the interest that goes unpaid gets put towards your student loan balance, and thus interest starts piling onto your interest. To avoid this, you should attempt to pay the interest on your student loan every month.
What Happens if You Cannot Avoid a Major Tax Impact?
In the same year that your student loan balance has been written off, you will receive a 1099-C that will indicate the amount that your student loan was forgiven. This will then need to be included on your 1040. If you are unable to pay the taxes on your loan forgiveness, then you’ll have a couple of options. You can ask for more time to pay your taxes and then get together a lump sum to handle the IRS debt. You may also ask that your taxes be made into a monthly installment plan so that their effect is not as drastic on your finances. However, realize that this will cause you to have more penalties and interest associated with your debt.