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For the most up-to-date information on federal student loan forgiveness, go to the U.S. Department of Education's Federal Student Aid website.
You may be celebrating if you qualify to receive the recently announced federal student loan forgiveness. In some states, however, you could be taxed on the forgiven portion. What felt like a clean slate for many student debtors may now have an unexpected smudge, but only a limited number of recipients could face taxation.
How much potential tax could depend on your location and income, so it's important to clarify what you may be responsible for. Here's what you need to know about federal student loan forgiveness and taxes.
What Is Federal Student Loan Forgiveness?
Federal student loan forgiveness announced in August forgives up to $10,000 for individual borrowers who make under $125,000 a year. Married couples filing jointly must make under $250,000 to qualify. Borrowers who used Pell Grants are eligible for up to $20,000 in forgiveness. Students and parents who took federal student loans can both be eligible for forgiveness.
This forgiveness builds on the payment and interest moratorium that was put in place by the CARES Act in March 2020. Loans that were affected by this moratorium are generally the loans eligible for forgiveness up to the specified limits.
Relief will be automatically granted to borrowers whose loans are on an income-driven repayment (IDR) plan. Other borrowers will need to submit an application to verify their income before having their qualified loans forgiven. Applications are not yet available as of this writing but will be available before January 2023, according to the Department of Education.
Typically, forgiven debt must be included on your tax return as income. But in the case of federal student loan forgiveness, the federal government will not tax the forgiven amounts.
This isn't necessarily true at the state level, however, and some states may have rules on the books that permit taxing the forgiven balance.
Who May Be Taxed on Their Student Loan Forgiveness?
Some states have existing rules which permit taxing forgiven or canceled debt as part of a state income tax. These states may be able to levy this tax against forgiven federal student loan balances.
Recipients of federal student loan forgiveness who live in these states may face a tax:
- Arkansas
- California
- Indiana
- Minnesota
- Mississippi
- North Carolina
- Wisconsin
Other states may make exceptions for federal student loan forgiveness, even if their rules typically say forgiven debt can be taxed. For example, Pennsylvania and New York have said they will not consider the forgiven student loan debt as taxable income. Other states may follow suit.
How Much Can You Be Taxed on Student Loan Forgiveness?
You can be taxed at your regular state income tax rate on your federal student loan forgiveness balance. If you're unsure of what that rate is, check your state's department of revenue services tax brackets.
Remember, tax brackets don't work by applying a single tax rate to your entire income; rather, they are tiered. Each tier of your income gets taxed at a slightly higher marginal tax rate. Check out this hypothetical state tax bracket system to see how much you would be taxed if you made $40,000 a year.
| Income | Tax Rate | Taxes Owed |
|---|---|---|
| $0-$10,000 taxed at 2% | 2% x $10,000 | $200 |
| $10,001-$25,000 taxed at 4% | 4% x $15,000 | $600 |
| $25,001-$50,000 taxed at 7% | 7% x $15,000 | $1,050 |
| Total tax bill | $1,850 |
As part of your income, your federal student loan forgiveness balance may increase your tax bill, but may not be enough to push you into a higher tax rate.
For instance, if you added $10,000 of forgiven loans to the above $40,000 income, it would still be taxed at a maximum of 7%. This would increase the overall tax bill to $2,550.
Forgiveness and Frustration
If you are eligible for federal student loan forgiveness but also live in a state that may tax your forgiven amount as income, you may be feeling frustrated. But some quick math can help you recognize that even paying extra in taxes now, student loan forgiveness will save you much more in the long term.
In the above scenario, if the forgiven $10,000 had been from a loan with a 5% interest rate with five years left, you would have paid over $1,300 in interest. When charged income tax you pay $700 now, bringing your total savings to just over $10,600 thanks to student loan forgiveness despite paying income taxes.
States that typically tax forgiven debt may decide to make an exception for forgiven student loans. Keep an eye out for any changes, and check with your tax preparer or state tax board to find out more as tax time nears.