With this new administration, one of the most discussed items is loan forgiveness. President Biden’s Student Loan Forgiveness Plan ranges in value from a one-time $10,000 up to a multi-year plan of $50,000. To date, it has not been one of the Presidential Executive orders signed.
As part of this loan forgiveness discussion, other issues were raised and it is not just the amount. Under current tax law, any debt forgiveness excluding specific statutes like Public Service Loan Forgiveness (PSLF) is considered taxable events. The other major item is the benefit may not be as immediate as expected for many borrowers.
Loan Forgiveness Tax Impact Under Current Law
Since Biden’s student loan forgiveness plan would be considered taxable under the current law, Congress would need to amend the IRS code to exempt this amount as a taxable item. Depending on the student loan borrower’s loan repayment method and current income the net amount could be different. This is especially true for student loan borrowers that are using an Income-Driven Repayment (IDR) method.
As an example, a single person who is making $60,000 would now have an income of $70,000. The tax on that additional $10,000 would be 22% using the 2020 income tax tables. For some borrowers, it could be a much higher percent, if they are married and file their taxes jointly. This same problem currently exists now with the end of term IDR forgiveness program. The IDR forgiven amount is currently taxable but we will not see any of those issues until 2027.
We have seen a similar process situation, with the extension of the tax-free employer student loan assistance benefit through 2025. This was initially added under the CARES Act and extended the tax code Section 127 relating to tuition reimbursement. It was then extended to 2025 through the Consolidated Appropriation Act.
One of the issues for President Biden’s loan forgiveness plan is this tax-free IRS provision does not exist at this time.
May Lack Immediate Impact for Some Borrower
We hear of the approximate 45 million people with student loans. A big misunderstanding about this number is it includes all borrowers with student loans. This means it includes both people in repayment and those still incurring student loan debt.
If $10,000 is the amount of Biden’s student loan forgiveness plan, it will eliminate the federal student debt of 15.3 million people. This is according to the Department of Education 2020 Q4 Student Loan Data. It will also accelerate the payoff date for the remaining number of borrowers in the future. For many, this could be years down the road.
Let’s see how this would work. Under a normal fixed loan repayment schedule, the $10,000 would be applied to the principal loan balance but the current monthly payment would remain the same. So for borrowers who have a fixed monthly payment, their financial stress may still exist. The workaround would be to either refinance the loan to a private loan with the lower balance or if the borrow has multiple federal loans they could consolidate which would extend the loan terms. In most cases, this would reduce the monthly payment amount. This will not work for federal borrowers using any of the IDR methods.
May Result in Higher IDR Payments
Since 2016, we have seen a growing number of federal borrowers use the Income-Driven Repayment (IDR) methods. Based on recent Department of Education data, over 56% of student debt dollars are now repaid using one of the IDR methods. This is a trend that not many people are talking about since these are more complex to understand.
The IDR methods were established to help borrowers have an alternative to staying current when their income could not support a higher fixed payment. The problem is that many believe that their monthly payment is paying down both principal and interest. That is not always true since the monthly payment is based on a borrower’s income and not the terms or amount of the loan like a traditional loan.
Assuming President Biden’s Student Loan Program is $10,000, under current tax rules, a borrower could have an income increase of $10,000. Under the current IDR calculation methods, this could increase their monthly payment by up to $125 per month.
Biden’s Loan Forgiveness Summary
With student debt being the second-highest debt American’s have, any assistance is helpful. Finding the best way to maximize this help maybe a little harder than expected. In the upcoming months and years, there are various Higher ED changes expected.
It is unclear when and how this will be implemented. There are some discussions that it may be limited to only certain types of student loans or limited based on income. PayForED’s student loan solutions and articles will help you stay up to date while making informed decisions.