Forgiven debt can be treated as income by the Internal Revenue Service (IRS), generating a tax liability when the debt is canceled. However, sometimes Congress will make certain types of forgiven debt tax-exempt. For example, the American Rescue Plan Act of 2021 temporarily exempted student loan forgiveness from federal taxation through 2025.
The most common misunderstanding is what forgiveness will mean for the borrower who reaches it. Many refer to the forgiveness as the “Tax Bomb.” That sounds scary and bad. But the mathematical reality is student loan forgiveness (even when taxable) will be a discount — a gift. A good thing!
Let’s take a closer look
Most veterinarians graduate with a student debt to income ratio greater than one — Their student debt balance exceeds their starting income. Anytime your student debt balance exceeds your income, traditional time-driven repayment methods are going to be financially difficult.
Federal Income-Driven Repayment options include Saving on A Valueable Education (SAVE, formerly the REPAYE plan), Pay As You Earn (PAYE), Income-Based Repayment (IBR), or Income-Contingent Repayment (ICR) plans. After choosing one of these repayment plans the borrower pays a minimum monthly payment as a percentage (10 or 15%) of their discretionary income.
Whenever your student debt to income ratio is greater than one, income-driven plans will provide monthly payment relief. For those with student debt to income ratios greater than two, income-driven plans will result in the lowest total repayment costs because of the forgiveness tax discount.
Student Loan Forgiveness: Tax Bomb or Discount?
Oftentimes, the monthly payment using an income-driven repayment plan is less than the interest accrual each month. The longer your monthly payment is less than the interest accrual, the more likely you will reach student loan forgiveness. Presuming the canceled debt gets treated by the IRS as taxable income, the amount of tax you will owe will depend on all of your taxable income, adjustments, tax filing status, state of residence, and tax rates the year the debt is forgiven.
The taxable fraction you will owe on student loan forgiveness cannot be higher than the top marginal federal and state tax bracket. Currently, the highest federal tax rate is 37%. The highest state tax rate is 13.3% (California). The worst case student loan forgiveness tax scenario using the tax rates in place now would result in a tax of 50.3% on your canceled student loans. Fifty cents on the dollar, otherwise known as half off, is a pretty good deal at any discount shopping sale.
Taking a closer look, your total income, including your forgiven student debt, must be quite high to reach those top tax brackets. Mathematically, that means your discount is likely to be even greater, with your overall tax on student loan cancellation probably falling somewhere between 25%-35% for most veterinarians. That’s a discount of 65%-75% on your remaining student loan balance. Your tax could be less, or it could be more. The exact number will depend on the tax rates in place when you reach forgiveness. Choose whatever tax rate you think makes sense to estimate your potential tax on forgiven student debt. Keep in mind, there are also seven states currently that have no personal income tax rates. If you live in one of those states when you reach student loan forgiveness, there will be no state tax on your cancelled debt.
When the forgiveness tax becomes a discount instead of a bomb, you can see more clearly why paying more than your minimum income-driven plan payment makes little financial sense. If you make additional payments towards a balance that is ultimately forgiven and you pay a fraction of the remainder, the additional payments decrease the discount — you voluntarily pay more than you have to for your student loans.
You also have to factor in the time value of money concept. A dollar today is worth more than a dollar in the future. The payment above what is required to your student loans today is worth more to you than the higher amount forgiven at a discount to you in the future.
If you’re headed towards student loan forgiveness, pay the minimum required by your income, and save for the potential tax on the canceled debt. To estimate your tax on student loan forgiveness, use the VIN Foundation Student Loan Repayment Simulator. The Forgiveness Planning Module can help you establish a reasonable tax target and show you how much you need to save each month to reach your target.
The alternative and more traditional approach to paying off your student loans are not wrong or incorrect by any means. However, make certain your personal situation allows you to do it. As much as we want strong will and fortitude to make the student debt statement read zero, your financial resources must allow for that pathway. Focus on more critical aspects of your financial wellness. Otherwise, you may put you, your family, your finances, and future at unnecessary risk.
Certain mistakes cannot be undone. Refinancing your student loans can forfeit all of the benefits included with your federal student loans. Forfeiting funds paid above what is owed cannot be used in other areas of your financial planning. Requesting or allowing a student loan deferment or forbearance can keep you in repayment longer and add thousands of dollars in interest to your bill. And no one yet has a time machine to go back and start saving for retirement earlier or your forgiveness tax sooner. Before making some of those undoable mistakes, please reach out to VIN Foundation for help.
Next Question: “How do I save for the tax?”
STEP ONE: GET STARTED!
There are hundreds of ways to save for long-term financial goals, including planning for the student loan forgiveness tax bill. As with any financial target, how you get there is going to come down to your comfort and risk tolerance. Your options fall along a spectrum from saving your money in a coffee can to using a Certified Financial Planner (CFP) and/or fee-only planner to manage it all for you.
Once you have a bit of savings, then you can consider moving your savings into other investments to increase your return. The higher your overall return, the less your forgiveness tax will cost you. However, seeking higher returns also comes with increased risk.
STEP TWO: USE TIME TO YOUR ADVANTAGE
You can certainly use only a savings account for your forgiveness plan. However, you’ll have to save more in order to reach your anticipated target. Instead, you may consider your forgiveness savings plan like you would retirement planning. Putting some of your forgiveness savings into investments like a mutual fund, target-date fund, exchange-traded fund, stocks, bonds, etc makes a lot of sense. Student loan forgiveness can take 20-25 years, depending on the plan you choose and how long you’ve been in repayment. These are usually long-term savings horizons where you have time to weather the ups and downs associated with more volatile investments. However, you have to be comfortable with the risks associated with that type of investing.
That said, investing has never been easier and cheaper. “Robo-advisors” like Wealthfront, Betterment, Acorns, Ellevest, Vanguard, Schwab, or whatever new one is popping up today have made it cheap and easy to invest in any combination of funds based on your risk tolerance. Robo-advising services are based on the same principle: low-cost, automated, passive index investing. Most allow you to choose your risk tolerance and how much you want to invest; the rest is pretty much on auto-pilot. NerdWallet has an excellent post that reviews several of the automated services available.
My wife and I use Wealthfront and Empower to help us save for the anticipated student loan forgiveness tax. This is not an endorsement of Wealthfront or Empower by any means. We went through the exercise of evaluating the available options and we decided this was best for our situation. I particularly like the frequency with which I can transfer funds into Wealthfront and their tax-loss harvesting feature which minimizes the taxes we pay each year on our forgiveness fund. I also like the robust aggregating features of Empower and optional personalized help when needed. There are numerous options to help you with your forgiveness and/or financial planning.
STEP THREE: MAXIMIZE YOUR RETIREMENT SAVINGS
What does saving for retirement have to do with forgiveness planning? Many veterinarians feel stuck, having to choose either saving for retirement or paying their student loans to zero first. Worse yet, I see some veterinarians using retirement funds to plan for their student loan forgiveness. The confusion can be compounded because investment services of any kind, like the Robo-advisers mentioned previously, usually allow you to open taxable or non-taxable (retirement) accounts.
I recommend using a dedicated taxable account for your forgiveness planning. Some financial planners will encourage you to use retirement accounts like a Roth or Traditional IRA to help you plan for forgiveness. Retirement plans are designed for and incentivize you to save for your future self — not student loan forgiveness. Do your future self a favor and maximize your retirement saving options for your RETIREMENT. Do not hijack savings from your future self to meet your student loan forgiveness target.
Forgiveness planning and retirement savings are separate but not mutually exclusive. You can and should do both. The income-driven student loan repayment rules actually incentivize you to do both. Maximizing your retirement contributions can reduce your taxable income which also lowers your income-driven monthly student loan payment. You pay less in taxes, have more funds to grow tax-free for your retirement, and you lower your student loan payment: win-win-win!
Working towards a forgiveness target:
With a well-diversified, moderately aggressive forgiveness planning strategy, my wife and I are more than 85% of the way to our forgiveness tax target with about 13 years to go. Stated plainly, we’re ahead of schedule. The more our forgiveness fund grows, the lower our total student loan repayment costs, because more of the gains come from compound growth. Starting your plan early and reaching your target early gives you more time to adjust if necessary. Once we reach our tax target, we can reduce the risk profile of the savings plan (maybe from moderately aggressive to something more conservative) until the potential tax is due. Start your forgiveness savings plan as early as possible.
You might ask, “why not use that forgiveness plan money to pay off your student loans now instead?” Unfortunately, that would only reduce our total household student loan balance by about 20%, eliminate an asset that is growing faster than our student debt balance, require the same monthly payment due on our student loans, and still have us paying a tax on forgiveness. Although our projected tax would be lower, we would still need a plan to cover a tax. That means we would have voluntarily paid more than necessary and hurt our family’s “balance sheet” while not improving our cash flow. Again, the forgiveness tax is more likely to be a discount than a bomb. There’s not a very good financial reason to pay more now when I will pay less later.
Income-Driven Student Loan Repayment Tip:
- Certified Student Loan Professionals (CSLP), https://cslainstitute.org/advisor-directory/
- CFP Let’s make a plan, https://www.letsmakeaplan.org
- National Association of Personal Financial Advisors, NAPFA.org.
If you are anticipating a student loan tax, start your forgiveness fund now! Use time to your advantage, to improve your chances of meeting your goal and decreasing your costs. Ask a lot of questions and adjust your plan as your circumstances change. One thing is certain — your plans will change. Leave yourself the most time to adjust to those changes and you’ll find it easier to reach your short and long-term financial goals.
Dr. Tony Bartels graduated in 2012 from the Colorado State University combined MBA/DVM program and is an employee of the Veterinary Information Network (VIN) and a VIN Foundation Board member. He and his wife have more than $400,000 in veterinary-school debt that they manage using federal income-driven repayment plans. By necessity (and now obsession), his professional activities include researching and speaking on veterinary-student debt, providing guidance to colleagues on loan-repayment strategies and contributing to VIN Foundation initiatives.
VIN Foundation
The VIN Foundation was founded by members of the Veterinary Information Network (VIN) in 2005. VIN is an online community of veterinarians and veterinary students with over 100,000 members worldwide. The VIN Foundation’s charitable efforts are centered around the belief that a healthy veterinary profession is essential for healthy animal and human communities.
3 thoughts on “Student Loan Forgiveness Planning: Preparing for the Tax Bill”
I’m in a sort of “different” situation. I had to stop working this year due to serious illness –so I have reluctantly “retired.” If I take social security I will have some income. Right now my husband is the only earner. I still owe approx. 18,000 on AES (not direct) federal loans, in repayment for 18 years. When I run the simulation, it doesn’t seem that refinancing will help me much. The loan will be paid off by the time I reach forgiveness period of 25 years. But the simulation says forgiveness would occur in two years. That would potentially still save some money if that is true. It also looks like IBR2014 would be my best choice for potential forgiveness but simulation says I would have to pay the entire loan in 2 years. I’m a little confused. I hate to “lose out” on something that would be helpful…?
Hi Jenny,
Thanks for posting your comment! As a veterinarian, I was able to see your student aid data file in the VIN Foundation My Student Loans tool. You have the loan types that must be consolidated first before you will receive any forgiveness credit under the one-time count adjustment. The first step is submitting a Direct Consolidation Loan application. You can choose any plan you would like for that consolidation loan until the count adjustment is applied (by Summer 2024). At that point, you’ll need to choose a forgiveness-eligible plan like ICR, IBR or SAVE. Your will not be eligible for IBR 2014 or PAYE. If you file your taxes separately from your spouse, you might have a very low or zero payment for your loans if you have little or not income. So visit with your accountant when you file your 2023 taxes and see what filing separately will look like for you. But first step is consolidating your loans so you can be eligible to receive the count adjustment.
If you need additional assistance, please post to the VIN or VIN Foundation Student Debt message board area and/or complete a student debt & income signalment form: https://surveys.vin.com/s3/VF-StudentDebtAndIncomeSignalmentForm
How confident are we that the federal loan program will still be forgiving loans after 20/25 years? I fear saving all this money for the tax bill, then having my loan plan change and suddenly I owe the entire amount that I can’t pay!