Archive for December 18th, 2012

December 18, 2012

Forgiven student debt can come with a catch – big tax liablity

by Grace

The relief that comes with having student debt forgiven under the federal Income-Based Repayment Plan (IBR) may turn to distress when the tax consequences become apparent.

The catch comes with the forgiveness, since you generally have to pay income taxes on any forgiven debt (unless you were in a program for teachers or worked in a public service job, in which case the taxes go away). For many people, especially those who finished graduate or professional school with six figures of debt, the tax bill could be well into the five figures. And when it comes, you are supposed to pay in full, immediately.

It’s difficult to predict how many borrowers will be affected, with millions of students potentially qualifying for reduced payments under the IBR program according to various sources.  One estimate by the Office of Management and Budget has several hundred thousand borrowers incurring an average federal tax bill of $10,000.

… The O.M.B. assumed that 400,000 borrowers from 2012 through 2021, each with a beginning average loan balance of about $39,500, would each eventually receive loan forgiveness of about $41,000. Yes, you read that right. The forgiven debt will be more than the original balance, albeit many years later.

At $41,000 of loan forgiveness, the federal tax bill could easily be over $10,000 depending on your tax bracket. There are also state income taxes to contend with, depending on where you live.

In some cases the forgiven amount could be much higher, as in the example of Stephanie Day.  Day foresees a tax bill on more than $100,000, the amount she expects will be forgiven after unsuccessful attempts to secure employment in her field after receiving a master’s degree in psychology.

Should these tax liabilities also be forgiven?

 … “Think about it practically,” he said. “You forgive someone’s loans, then you stick them with a tax bill that’s equivalent to making three or five or 10 more years of payment on the loan.”Representative Sander M. Levin, Democrat of Michigan, has tried and plans to continue to try to get a law passed that will take away the tax burden, according to his spokesman. The odds of this happening anytime soon, however, are probably pretty low in the current political environment.

It might not seem fair that someone currently earning six-figures would receive a $200,000+ windfall from other taxpayers.

“Let’s say your debt has grown to $180,000 over 20 years, and by that point, you’re making $120,000,” he said. “If $180,000 is being forgiven, then you’re looking at paying taxes on $300,000 in total income in one year. At that point, you’re over the $250,000 income category, my friend.”

A program that forgives student loans and related tax liabilities seems ripe for opportunities to game the system.  Tax professionals are very familiar with schemes of timing income to take advantage of government loopholes.   And there’s at least one enterprising group already hoping to profit by “helping those burdened by student debt become aware of their repayment options” and aiding young professionals in “utilizing government programs”.

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