If you get your student loans forgiven, there are situations when you may have to pay taxes on the amount of student loan debt forgiven.
While some student loan forgiveness programs, like Public Service Loan Forgiveness (PSLF) are tax-free, others - like when you get your student loans discharged under Income-Based Repayment, are potentially taxable.
However, there's one big exception - insolvency. Insolvency is a tax situation when your liabilities (such as forgiven student loan debt) exceed your assets (like the money in your savings account). If you are technically insolvent, you may avoid some or all of the taxes associated with your loan forgiveness.
That is a big win for borrowers getting their loans forgiven under IBR, PAYE, RePAYE, or ICR. Let's break down what that looks like.
What Is Student Loan Forgiveness?
There are four main areas of student loan forgiveness, and each has it's own taxability. We've talked about student loan forgiveness and taxes before, but here's a quick summary.
1. Federal Student Loan Forgiveness Programs - These include programs like PSLF, which are tax free student loan forgiveness programs.
2. Student Loan Repayment Assistance Programs - These are state-based or company-based student loan repayment programs, such as when your employer gives you $5,000 per year towards your student loan debt. These programs don't qualify for insolvency, but the amount awarded is typically considered ordinary income.
3. Student Loan Cancellation - These are programs that allow for the cancellation of your student loans. Some are considered taxable income, others aren't. For example, if you have your student loans cancelled due to a closed school discharge, that is considered taxable income. However, if you get your student loans forgiveness due to total and permanent disability, that is tax free (thanks to President Trump's Student Loan Programs).
4. Student Loan Forgiveness Due To Repayment Plan - This is when your student loan balance is forgiven at the end of your repayment plan when you're on income-driven repayment (like IBR, PAYE, RePAYE, ICR). This type of student loan forgiveness is considered taxable income and could potentially qualify for insolvency.
What Is Insolvency?
Insolvency is a technical tax term meaning that your liabilities (what you owe) exceeds your assets (what you have). When it comes to student loan debt, the forgiven debt is considered income - which you'll receive a 1099-C for the cancelled debt. That amount must be reported and there will be taxes due on that "ghost" income unless the borrower can show they were insolvent at the time of forgiveness.
To figure this out, you must calculate your "insolvency amount". This is the difference between your assets and liabilities. If your insolvency amount is greater than the forgiven debt, then you can exclude it and not pay taxes on it. If the insolvency amount is less than the forgiven debt, you might have partial insolvency.
It's important to note that for the purpose of insolvency, the IRS takes into consideration all assets you own. This includes the basics like checking and savings account, and investments, but also includes things like your retirement account values, your real estate, any business ownership, even the value of your possessions.
To figure out the liabilities, you include any debt owed (like credit card debt, mortgage debt, etc.), along with the amount of forgiven debt (your student loans).
Example Of Total Insolvency
Let's take a look at an example of total insolvency to highlight how this works. This situation could apply to many borrowers dealing with student loan forgiveness, so it's a good example of what can happen.
This borrower has been on IBR for 25 years, and the loans have grown to $70,000. However, he did manage to save a little in a 401k, and does have a few assets.
Assets | Liabilities |
|---|---|
Checking Account - $2,000 | Federal Student Loan - $70,000 |
Car - $8,000 | Private Student Loan - $65,000 |
Personal Stuff - $5,000 | Credit Card Debt - $10,000 |
401k Value - $45,000 | |
Total Assets - $60,000 | Total Liabilities - $145,000 |
In this example, he has total assets of $60,000, and total liabilities of $145,000. That makes his insolvency number $85,000. Since his student loan debt was $70,000, and that's less than the insolvency number of $85,000 - the total amount of student loan debt "ghost" income will not be considered taxable income.
Example Of Partial Insolvency
Let's look at an example of partial insolvency, which is more common for borrowers. In this scenario, there's more student loan debt, and slightly more assets.
Assets | Liabilities |
|---|---|
Checking Account - $2,000 | Student Loan Debt - $170,000 |
Car - $8,000 | Credit Card Debt - $10,000 |
Personal Stuff - $5,000 | |
401k Value - $65,000 | |
Total Assets - $80,000 | Total Liabilities - $180,000 |
In this case, the insolvency number is $100,000. Because the amount of student loan debt ($170,000) is larger than the insolvency number of $100,000, he still must include the remaining $70,000 as taxable income.
Why Most Borrowers Shouldn't Worry About Taxes On Their Forgiven Debt
For most borrowers who are getting student loans forgiven, you shouldn't worry about the future tax implications of it. Making payments under an Income-Driven Repayment Plan are usually the best case scenario - if you could afford full payments, you would. You're on these plans because it's better than the alternative - default.
Second, 20-25 years is a long time. There could be major changes to tax legislation before any amount of the debt is forgiven and potentially taxable.
Finally, the math still works in your favor. Only in extreme cases should larges amounts of debt be full taxable. Most borrowers will see themselves receiving total or partial insolvency, which will significantly reduce any tax burden.
And realize, you're now paying taxes on a much smaller amount of debt. For example, in the partial insolvency situation above, let's see how that would play out given current tax brackets. Let's assume this was a single guy or gal, making $45,000 per year. The taxable income of $70,000 would boost the total taxable income to $115,000. That moves him or her from the 22% tax bracket, to the 24% tax bracket.
However, it's ghost income - meaning that you have to claim it even though no income came in. And that tax liability could hurt. That bumps his total tax bill from $3,770 to $19,010 - a huge change of $15,240. That's a big amount to pay. But, look at the big bright side. You just went from owing $170,000 on your student loans to owing just $15,240.
You can easily setup a payment plan with the IRS, make some quick financial changes, and eliminate that debt rather quickly.
For smaller amounts of debt, the math works out even better.
Final Thoughts
As with anything involving taxes, the math gets tricky, every situation is different, and you should really seek the advice of a tax professional when handling insolvency. It's complex, it has a high likelihood for audit, and so you want to make sure you do everything correctly.
The big lesson here is to not fear the tax consequences of the secret student loan forgiveness programs. Yes, there are tax consequences, but they are manageable and better than any alternative out there.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.
Kyle says
Curious….What do you think of this article regarding PSLF?
https://www.cnbc.com/2018/09/21/the-education-department-data-shows-how-rare-loan-forgiveness-is.html?fbclid=IwAR09nzKDAvtm1iQkhjalQx9HZ9SDSacE_aQX9kttu1ajeLlJHah0GKrin_Y
Robert Farrington says
Basically, the program is doing exactly what I’d expect it to be. Here’s my response: https://www.forbes.com/sites/robertfarrington/2019/01/22/why-the-public-service-loan-forgiveness-headlines-are-misleading/
Jennifer Hansen says
Hi. Ive been on the IBR plan since I graduated in 2012. I got married 5 years later. I can’t seem to get any solid answers from my loan managers (Navient) about income? They tell me that if I have access to my husbands accounts, then they will consider his income for basis on my payments. That doesn’t seem fair because my student loan debt is 100% mine. I was 5 years graduated when I met him. So we must keep sperate bank accounts for that reason. But what about filing jointly on taxes? Will that increase my payment? Why? This shouldnt be his burdon. I’m getting hit hard with taxes having to file married but seperate! Even when I claim married withold at higher rate on my w-4!!! I just want to make sure this is my only option. Thanks
Robert Farrington says
If you file your taxes jointly, your combined AGI is used to calculate your repayment. If you file separately, just your income. However, there are negative tax consequences for doing it, and it may not be worth it.
See this: married filing jointly or separately for student loans.
Amy says
I received a letter from the department of education and an application to have my loan forgiven from Everest University. That school got in trouble for fraud and was ordered to pay millions back to their students. I never made any payments because my loan was deferred so my loans were Not in default. Anyways I filled out app in 2016 and loan was forgiven the beginning of 2017. I haven’t received anything in the mail about paying taxes. It’s been over 2 years. Should I be worried about paying taxes. Please help.
Robert Farrington says
If you didn’t receive anything, you shouldn’t worry.
But, you should ensure that your loans really were forgiven. Double check your loans to ensure they are all paid off: https://thecollegeinvestor.com/19370/how-to-find-out-who-owns-your-student-loans/
esotercia phillips says
My income was kept this and we in the co- 19 will the govt give you some of your money back.there is no school and I need some money.
Michelle Ruby says
I entered into an employer loan agreement to assist with paying for college. I worked a certain number of years and they were to forgive debt. I still had debts greater than assets and had planned to claim insolvency and avoid the tax implications of the forgiven debt. I thought I would receive a 1099C to claim insolvency, but received a 1099-MISC , non-employee compensation, that is not eligible for the insolvency claim. Can you help with what I am missing? Is debt forgiven through an employer not eligible for the insolvency clause?
Robert Farrington says
Correct, an employer paying your student loans is considered income – basically like a bonus your company is giving you. So you will pay taxes on the amount.
A company/employer cannot forgive your debt, they can just give you money to pay it.
As such, you don’t qualify for insolvency as there was no cancellation of debt. You simply had it paid off.
Kay says
My daughter received several 1099-C’s for cancellation of a student loan. She had received a B-Ontime loan and met the qualifications of graduating within the set time frame. Her assets total around, maybe $700 and the loan forgiveness is over 43k Is this an instance insolvency would qualify?
Robert Farrington says
Likely, but given the tax dollars at stake here, it’s best to work with a tax professional to file the correct forms accruately.
Grace says
My son had exactly the same and did this. He qualified.
Anna says
First, thank you for the article. What still worries me about the idea of insolvency is the fact that I may gain many more assets over the period of 21 years. I would imagine that part of the point of lowering the monthly payment with an IBR plan is to be able to use money for other things like down payment of a condo. If I end up paying off a small condo in 21 years it seems I have little chance of having a huge gap between my assets and my six figure student loan. Especially adding inbthe value of my 401k 20 years from now.
Does this only work if you intentionally try to keep your assets low? Would gaining ownership of a partners assets through marriage affect insolvency as well?
Thanks
Robert Farrington says
Remember, your IDR payment is based on your discretionary income – 10% or 15%. To have a really low monthly payment, you also don’t make a lot of money. Your 401k definitely has potential, especially if you get an employer match, but the odds of gaining a lot of assets versus a lot of debt is typically pretty rare.
Now, if your income goes up, you’ll have the potential to gain more assets, but you also have the ability to pay down your debt much faster (and you’ll also see your IDR payment rise anyway).
Remember – the government only offers these repayment plans because they are betting on you NOT getting forgiveness. They see the statistics and know that most people will see their incomes rise of 20 or 25 years, and they’ll get the majority (or all) of their debt paid off before forgiveness.
As for marriage – if you do get married, you may want to file separately for the year you expect to get a 1099-C so that your assets are just yours. You might also look at this: https://thecollegeinvestor.com/17807/the-math-behind-married-filing-separately-for-ibr-or-paye/
Zach says
My current payment on IDR is $0 month on $82,000 principle and 12,000 unpaid interest. Interest is still accruing and I have 22 more years before it’s forgiven. To just simply break even in interest at this point I’d have to pay $450/month.
In 22 years I’ll owe way more than I do now because of the accruing interest. I am in a profession that I will never make a lot of money. I’m wondering if I should even try to make the interest only payments at this point or just let it go and accrue.
Robert Farrington says
You definitely shouldn’t pay more. Pay what you can afford, save what you can.
Have you considered working in public service or for a non-profit? Then you can get Public Service Loan Forgiveness in just 10 years tax-free.
Zach says
I’ve considered that but I’m a pastor and I didn’t think pastors qualified for PSLF
Zach says
Also- you don’t think I should pay the $450 to keep the interest from accruing? My principle won’t go down at all.
I guess the more it accrues the easier it’ll be for me to stay in IDR
Robert Farrington says
Correct, pastors don’t get PSLF. Also, you shouldn’t pay it unless you can easily afford it. Maximize your loan forgiveness. The higher the likelihood of insolvency and still being able to save a little something.
Andrew says
How would this work with a mortgage that has a balance on it? Is this also considered a liability ?
Robert Farrington says
Your mortgage is added to the liability column for calculating your insolvency.
Christine Om says
For the Pay As You Earn (PAYE) and IBR options of loan repayment is the loan forgiveness guaranteed if you make the 120 monthly payments or is it like the Public service option where you are eligible to apply for forgiveness at that point?
Robert Farrington says
PAYE and IBR have loan forgiveness that’s guaranteed at the end of the repayment plan – which is 20 or 25 years depending on the underlying loans. This is simply an aspect of the student loan repayment plan.
PSLF is 120 payments and has other requirements.
This may be helpful: 4 Types Of Student Loan Forgiveness With Respect To Taxes.
Charles says
I’m having trouble finding an answer to this question and your example above is the first one I’ve see that clearly shows what I’m curious about.
As the wording of the insolvency section in Publication 4681 states “don’t include a canceled debt in income to the extent that you were insolvent IMMEDIATELY BEFORE the cancellation” I believe I can count the forgiven debt itself as a liability? Other sites/examples have been unclear whether I can include that cancelled debt as a liability or I include only my other liabilities.
Any clarification on this?
Robert Farrington says
Yes, you take the snapshot of your assets/liabilities at the time of insolvency – which for this example of student loans, you would include that student loan balance on your liability sheet along with other debts (like credit cards, car loans, etc.).
Sarah says
This was so informative. What I’m left asking myself is who can I talk to about my different options? The government entities holding my loans?
Robert Farrington says
What do you mean? The different repayment plan options?
Ariel says
Hi thank you for this article it’s so helpful. One thing I am worried about and trying to figure out is what would my husband’s liability be regarding my taxes in 25 years? For instance what if I had a large tax bill from not being insolvent…if I filled married filled seperately would that prevent this from being my husband’s responsibility at any point? I’m afraid I end up with a tax bill and then die somehow leaving him on the hook. Or perhaps we should consider divorce a couple years ahead of time and seperate all our assets so I will definitely be insolvent. I know maybe you can’t answer this but maybe you could point me to an article or something with more info on this kind of scenario. Thanks again.
Robert Farrington says
Two questions here – 25 years down the road, and what if you die.
25 years down the road, if you’re seeing a 1099-C for the debt, you can assess your insolvency. On the Federal level, if the debt was pre-marriage, you should be able to use just your assets. State-level may be different depending on if you’re in a community property state. But this is also a complicated tax topic, it may change in the future, and it’s best figured out by a tax professional that understands insolvency and canceled debt. You honestly can’t even worry about it until you’re close (within 5 years or so), because there is nothing you can do until then.
For death, your Federal loans are forgiven when you die, and this is tax-free loan cancellation currently (due to Trump’s student loan changes). For private loans, if he is the cosigner, he’s 100% liable for the debt unless your lender has a death discharge (which most don’t). You may consider simply taking out a life insurance policy for the amount of the debt that’s payable to him if you die. That would cover it, and it would be relatively cheap if you’re young and healthy (even as low as $5 per month).
Emily says
I have read that 2019 is the first year that a lot of the IBR loans are hitting their forgiveness point so this would be when legislation starts moving faster to address how tax debt will be calculated. Do you know of anything on the horizon to address the tax implications to make it easier to plan for that day? I have about 15 years left of my IBR plan and my debt is nearing $200,000 due to never hitting my principal since I’ve been on IBR. Should I pay more to at least satisfy the interest so I know it is capped where it is and plan for the tax debt based on that amount, or save as much as possible, let my loan principal grow and hope that I’m at least partially insolvent when that day comes? I just worry that if I plan for insolvency rather than working toward reducing my principal, in 15 years there could be no account for insolvency and I’ll have a massive tax debt.
Robert Farrington says
Insolvency has existed as a tax code for decades. That isn’t changing. What may change is the government may make it tax-free – in which case you may have been incentivized to save more… but neither comes at a cost of your debt.
Note, some states, like CA, already treat loan forgiveness due to IBR as tax-free. So at least you don’t have to worry about it on the state-level in certain places.
Derek Ketcher says
when you say tax free insolvency…does that basically mean if i pay on my IBR for 20yrs at the end the balance…let’s say 60,000 is just swallowed up and not added as taxable income?
Robert Farrington says
You still report it on your tax return, but you claim insolvency if you meet the criteria above in the article. As such, yes, that $60,000 won’t be treated as income.
Derek Ketcher says
thanks for the reply! Do you see the govt realistically eliminating the tax bomb in the future? Also, do you recommend just paying the IBR amount and hope the laws change while keeping you assets low and having keeping your taxable income low as well when loan forgiveness roles around?
Robert Farrington says
Maybe… some states (like CA) already make it tax-free.
Honestly, if you’re on an income-driven program, it’s rare you’re going to be able to stash a lot away. If you could afford more, you probably will be paying off the loan before forgiveness – in which case, you might as well work towards eliminating it as quickly as possible.
Those who have the biggest “tax bombs” are going to be the ones with huge negative amortization – such as $0 monthly payments. But along with that, if your payment is really that low, there is a near-zero chance you’re saving much either.
So, naturally, you’re probably going to be keeping your assets low, and if your not, then your better mathematical deal is likely paying off the loans faster.
Jessica says
I am 259,000.00 in student debt. My loans were deferred or forbearance due to attending schools or having children in school. Now, my husband is unemployed and disabled. Student loans are now garnishing my wages of 440.00 a month. I informed them last year when my husband became disabled with no response. Do I have any options?
Robert Farrington says
You need to:
1. Get out of student loan default
2. Get on an income-driven repayment plan
Douglas In Dallas says
My student loan debt is out of control due to circumstances back in in 1992. I’d borrowed several small loans totaling $16,000 from the same bank with the assumption I could consolidate them when they became payable after graduation. I received a call from a collector I didn’t know so I asked for back up on who they were only to find out the original lender didn’t update my mailing address on all the loans so some of them that were “guaranteed” received payment from the federal government and some went into default with a higher interest rate. Because of the consolidation rules, when they were combined into one loan, the interest rate was the highest of all the loans (the defaulted loan’s interest I think is seriously may be 9% or 19%). I was able to include the student loan in a bankruptcy that was discharged in 2008 and see a little relief, but because the interest on my loans literally adds $450/month to the debt, my $16,000 in loans now is at $64,000 and after my most recent Income Based Repayment plan will be at $94,000. Before the IBR was approved I kept deferring and forbearing during unemployment and financial hardships because I couldn’t afford the $750/month payments. Now that I’m divorced, my IBR is supposed to drop down to $170/month. Did this new IBR reset the 20/25 year forgiveness? My loan now says original dispursement is May 2002… Do any of the deferment or forbearance periods count for any of the time or do I literally have to make payments for another 20 years?
Robert Farrington says
Same loan, same clock. Your income changing doesn’t impact the forgiveness clock. Your deferment periods count as well. So, as long as you’ve been on the same loan and repayment plan since 2002, you should hopefully see 100% relief in about seven more years…
Stan says
I have nearly 450k in student loan debt from professional school, 90 of that alone has been in interest. They are all direct consolidated loans. I just started (last month) in a PLSF program, but also planning on finishing through the REPAYE program (25 years) should the PLSF fail. Ideally I’ll successfully complete the PLSF. I input a few calculations as my joint income is 115k, and with the REPAYE program its predicting ~890k in loan forgiveness at the end of 25 years. My monthly payment would be 500-700, and would truly never bring the principal down. I would have nearly 95k in mortgage payment left by the end of the REPAYE (in 25 years), and I estimate my assets at ~300k (do I include my home’s value as well even though I would still owe 95k?). Do you think I should concentrate on larger principal payments or keep to the smaller payments? Will the 890k be considered taxable income (assuming I make it through the 25 years in REPAYE because PLSF went away) or do you think I’ll qualify for full/partial insolvency, if so how much would you predict would be the taxable amount and tax percentage for this example? Would I ever be taxed fully on the 890k–if so how much would that be? How do you calculate the tax percentage? I saw in your example the partial insolvency guy paid 19k in tax/ for 115 in “income” which would make it around 16%–is that a correct?
Additionally, do you see REPAYE/PAYE/PLSF ever being revoked?
Robert Farrington says
First, if you’re going for PSLF, it’s 120 payments, and it’s tax-free loan forgiveness. I get worst-case scenario planning, but if you stick to that plan, you’re set. It’s not hard, and while the early stats were bad – it was honestly because most people that applied were wrong – not the program. See my article on it: Why The PSLF Headlines Are Misleading.
With that being said, the programs may go away or change. The repayment plans and even PSLF. But what usually happens when things change is that people eligible are grandfathered in, and the new rules/programs apply to borrowers who take out loans after X date. The reason? They add all these programs into your loan docs. So, they can’t really just change your loan docs for existing loans without a lot of controversies, lawsuits, and more. If it does change, you’re probably fine.
Finally, all taxes are calculated as ordinary income. So, it’s your best guess what the top tax brackets will be in 25 years – if you really pay on the full $890k, plus your AGI, you’re looking at like $1m in income that year. So, assuming 38% Federal and 10% state – you could see a tax bill approaching $450k…
But remember, that’s all hypothetical. Focus on doing your PSLF correctly. Most people mess up by not filling out the documents correctly, not being on the correct repayment plan, or not having the correct loan types.
Will says
I’ll be roughly in the same situation, except my total stucent loan debt is currently at about 360k. All my student loans are in default. I’m considering rehabilitation for 9 months followed by REPAYE plus possibly PLSF? In 25 years I’ll be 70 years old so I’m not sure what my health status will be like at that point or if I’d be able to be capable of working at that point. Will earn roughly 120k a year, probably much less that that in my first year of work in 2020. What happens if I retire before the 25 year REPAYE term and cant afford to to make payments for the remainder of the term? Or Let’s say I make it to 70. What would the tax bomb be roughly after 25 years? Are there any loopholes, discounts, or benefits for senior citizens or any elder qualified age that are stuck in this situation?
Robert Farrington says
You definitely need to get out of default no matter what. Rehab is the best way.
As for your questions – RePAYE is based on your income. So, if you get to 65 and retire and have no income, you’d simply recertify your income at that level ($0, but likely would be something due to retirement, etc). Your loan payment would then adjust accordingly, and be as low as $0/mo.
The tax bomb is all based on your debt forgiven (if your solvent), times your tax bracket. Your tax bracket is always a bit of an educated guess. Both your income and the laws could change.