The $1.9 trillion economic stimulus bill aimed at relieving the continued impact of the pandemic, signed March 11, includes Section 9675 for the “modification of treatment of student loan forgiveness.”
The new provision changes how the IRS treats canceled student loans. Normally, canceled debt is included in your gross income and subject to income tax. The modification excludes canceled student loans from your gross income if that loan forgiveness occurs between 2021 and 2025. The gross income exclusion applies to federal loans made for postsecondary educational expenses and, it appears, private loans made for the same purpose.
The most common way for student debt to be forgiven, or canceled, is when borrowers who have been making payments based on a percentage of their income reach the maximum repayment period, 20 or 25 years, with a balance remaining. Unfortunately, there are very few people who have received student loan forgiveness using an income-driven repayment plan. There are a couple of key reasons for that, most of which have not been mentioned in early analyses I’ve read of the new loan forgiveness modification.
To explain why, I need to take a step back.
There are four federal income-driven repayment plans that can result in forgiveness: Income-Contingent Repayment (ICR), Income-Based Repayment (IBR), Pay-As-You-Earn (PAYE), and Revised-Pay-As-You-Earn (REPAYE). While they are similar in principle — you make payments based on your income and family size until you either pay the balance to zero or you reach forgiveness after a specified number of payments — they also have significant differences.
ICR has been around the longest. It was first available to borrowers in 1995. The earliest that borrowers under ICR could have become eligible for loan forgiveness was 2020.
Regrettably, ICR didn’t provide much in payment relief for those who may have been eligible to use it back in 1995. The monthly payments were 20% of the borrower’s discretionary income, a relatively high proportion. Therefore, most borrowers under ICR either paid off their loans before reaching forgiveness or switched to a repayment plan that provided a lower monthly payment but did not result in forgiveness.
ICR was income-driven repayment version one. Think of it as the flip phone of income-driven repayment. I certainly wouldn’t expect the flip phone to connect to the internet, store multi-gigabyte pictures, make video phone calls, provide driving directions, schedule life and have a battery that would last all week. The same is true for ICR — it was the start of something that has improved over time and will likely continue to improve. It has to. Even if the current administration canceled all $1.6 trillion dollars of student debt, there will still be a need for student loans and reasonable repayment plans to manage those loans.
Compared with ICR, the newer versions of income-driven repayment provide for lower monthly payments (10-15% of discretionary income) and have shorter repayment periods. Therefore, they are more likely to result in forgiveness, particularly if you owe more than your annual income.
The newer options did not become available until 2009 (IBR), 2012 (PAYE), 2014 (new IBR), and 2015 (REPAYE). The earliest that borrowers who started repayment under any of these plans will qualify for forgiveness is 2032. That is seven years after the new forgiveness tax exemption expires.
There are also an unknown number of borrowers who may have started in ICR and managed to switch to a more beneficial income-driven repayment plan in 2009 or later who may benefit from the forgiveness tax exemption allowed in 2021-25.
Going back to the 3% in ICR: Included in and complicating those stats are Parent Plus borrowers. ICR is the only income-driven repayment plan that parents can use to earn forgiveness on federal student loans they borrowed to help pay for their children’s education. (The fact that parents can use only ICR among all the income-driven repayment plans is another pill poisoning federal student loan repayment.)
Ultimately, knowing exactly how many borrowers are headed for student loan forgiveness and when is extremely difficult since there is not yet a good way to track the number of years borrowers have made qualifying forgiveness payments. This, as well as enabling parents to use more beneficial income-driven repayment plans, are things that Congress, the U.S. Department of Education and the loan servicers need to fix as soon as possible.
There is reason to be excited, confused and frustrated with the student loan forgiveness modification.
I think this modification makes it more likely that we’ll see some kind of student debt cancellation in the short-term by executive or legislative action. If so, whether you have federal or private student loans, whatever amount might be canceled would most likely not be subject to federal taxation.
The modification also opens the door to exempting student loan forgiveness from taxes permanently.
Not only is the universe of borrowers who will benefit from the new exemption too small, but the law makes no provision for borrowers who reached forgiveness through ICR in 2020. So any poor soul who managed to have their loans canceled in the most recent tax year will have to pay a tax when they file, making them completely screwed by the structure of this amendment. Thankfully, there are probably very few to no souls in that situation.
The modification also makes it possible to screw people in the future if Congress does not continually extend or make the tax exemption permanent by the time most borrowers experience student loan forgiveness. Essentially, we’ve now made student loan forgiveness a political football, which leads me to the frustrating parts of the modification.
If they know there will be a tax on their student loan forgiveness, borrowers can plan for it by saving money to cover that bill. However, many borrowers need the entire maximum repayment period to have a chance to save enough. If there’s not a tax in the future, great! That’s less to worry about in repayment and more room to focus on other areas of financial wellness.
However, Congress has arguably made it more likely that borrowers will fail to plan or consider saving for a tax that they may still have to pay. That might be genius on the part of the senators who think they have a crystal ball showing that the forgiveness modification will certainly be extended. Or it is completely irresponsible if the provision expires as scheduled — and people who had been lulled into believing the tax exemption would be extended lose at least five years to save for the potential tax bill.
My wife and I have $400,000 of veterinary school student loans we manage using REPAYE. We are due to reach forgiveness in 2037. When word of the modification surfaced, we briefly mused about what we might do with our forgiveness fund if we no longer had to pay the tax. Then we saw the devil in the modification details. There is no way we can stop planning for the forgiveness tax. What little certainty we had before around the tax has now been replaced with greater uncertainty and elevated expectations that the tax should be eliminated going forward.
So what do we do now? Plan for the worst and hope for the best. If your student loan forgiveness will be outside the new modification window (which is the case for nearly all outstanding student loan balances), then keep planning for the tax on your student loans and keep your fingers crossed that we see some type of cancellation in the next five years or a permanent extension of the forgiveness modification.