Americans now owe an astonishing $956 billion in student loan debt. The rate of student loan debt outpaced inflation last year – and keeps climbing. I should know: I am one of those still working to pay off student loan debt. I borrowed to pay for my education because I couldn’t afford to go otherwise.
I understand that part of borrowing means paying back. I am fortunate in that I am in a position to pay my loans back – albeit slowly – because I have a job. With unemployment rates at near all-time highs, not every one is in that same position.
There is some relief available for those who have borrowed and are near default: loan forgiveness programs allow certain borrowers to reduce their monthly payments in order to pay what they can afford. The rest of the loan, at the end of the repayment schedule, is forgiven.
Awesome for those folks, right?
Not quite.
The problem with the plan, as with many such debt relief initiatives, is that the forgiven debt is considered taxable income. Depending on the amount of forgiveness – and the timing – that can result in a huge tax bill. How huge? Consider this: many students (including myself) owe more in student debt now than originally borrowed, despite making payments. Interest accrues beginning at the first dollar owed which means that students, especially those in graduate school programs, could accumulate more debt while still in school.
Even if students start paying back immediately, the cost of an education can nearly double. With a repayment schedule of 20 years, interest on a $40,000 loan can easily reach $30,000, even with a moderate interest rate. At the end of the term, it’s not unlikely that you’ll have paid nearly as much in interest as you have in principal – assuming you can afford it. If you can’t, and you qualify for one of these federal programs for forgiveness, you’ll have the remainder written off. Sort of.
That remainder would be subject to tax – at your then marginal tax rate. That means that you could replace one bill (student loan debt) with another (tax debt).
Here’s an example. Let’s say you borrow $40,000 and accrue $30,000 interest (20-year payback at 6%). At the end of the term, let’s say that the remainder of your debt is forgiven. To keep math simple, let’s say that the balance due is still $40,000. If you’re making $50,000 at that time, your taxable income is $50,000 plus the $40,000 in forgiven debt. The extra tax bill? About $11,000. Ouch.
The good news is that the tax won’t be due for a few years – after the loan is forgiven – assuming, of course, that nothing changes. Start saving now.
(H/T: ABA Journal)
