If you’re poised to benefit from President Joe Biden‘s up to $20,000 in student loan forgiveness, you may also be wondering if the erased debt will trigger a tax surprise come April.
The short answer is: It won’t, at least on your federal tax return.
Biden on Wednesday announced that he will forgive $10,000 in federal student debt for most borrowers, limited to borrowers making less than $125,000 per year, or $250,000 for married couples filing together or heads of households.
He will also cancel up to $20,000 for Pell Grant recipients, Biden said in a tweet.
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Tax-free forgiveness on up to $20,000 may offer significant savings, depending on your income, said certified financial planner Ethan Miller, founder of Planning for Progress, based in the Washington area.
For example, let’s say you’re making $40,000 per year in the 12% federal tax bracket. If you receive $20,000 in tax-free student loan forgiveness, you’ll avoid $2,400 in federal taxes.
Student loan forgiveness can incur federal taxes …
To be clear, student loan forgiveness won’t trigger a federal tax bill.
Generally, the IRS sees federal student loan forgiveness as taxable earnings. However, some exceptions are tax-free, such as the relief that comes with public service loan forgiveness, designed for government and nonprofit workers after 10 years of payments.
“It’s a patchwork, because all of these programs were created separately at different times,” Miller said.
Taxable student loan forgiveness often creates a significant burden, especially for lower-income borrowers with large balances, Miller said.
… and you may owe state taxes on forgiven debt, too
While Biden’s student loan forgiveness won’t trigger higher federal taxes, you may still be on the hook for state levies, said higher education expert Mark Kantrowitz.
Some states automatically conform to federal rules, but others may count the forgiven balance as income, meaning it’s still possible you’ll have a bill. The amount “may be the equivalent of a few student loan payments,” Kantrowitz said.
If you’re unsure, contact a local tax professional for an estimate before filing your state tax return.
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How to handle student loan forgiveness on your return
It’s not yet clear what extra steps borrowers may need to take at tax time, if any, to account for the up to $20,000 in forgiveness.
Typically, when lenders forgive at least $600 of student loans and it’s taxable, they’ll send borrowers and the IRS a copy of Form 1099-C, which includes the exact amount of canceled debt, said Tommy Lucas, a CFP and enrolled agent at Moisand Fitzgerald Tamayo in Orlando, Florida.
While non-taxable forgiven debt generally doesn’t require a 1099-C, experts say it’s possible IRS guidance will change in the coming months given the significant number of borrowers that Biden’s announcement affects.
Either way, you’ll want to make sure your servicer doesn’t report your loan forgiveness as taxable, as it may cause a mismatch on your return.
How forgiveness affects the loan interest deduction
Borrowers with federal or most private student loans are usually able to subtract up to $2,500 a year in interest payments they’ve made on their loans from their gross income, reducing their tax liability.
The deduction is considered “above-the-line,” which means you don’t need to itemize to qualify for the break.
There are income phaseouts, and individuals who earn above $85,000 and couples who make more than $175,000 in 2022 are not eligible at all. Your lender is supposed to report your interest payments to the IRS on a tax form called a 1098-E, as well as provide you with a copy. You claim the deduction on line 20 of Schedule 1.
Most borrowers haven’t been eligible for the deduction in more than two years because they haven’t been making payments on their loans.
Since March 2020, the government has allowed most borrowers to press the pause button on their payments without interest accruing. “You can claim the student loan interest deduction based only on amounts actually paid,” Kantrowitz said.
If the debt forgiveness cleared your balance entirely, you’ll no longer be able to claim the deduction. Yet you should be eligible if you’re still left with student debt and resume your payments.
More than 12 million taxpayers claimed the student loan interest deduction in 2018, with tax savings of up to $550, according to Kantrowitz.