Surprise! Student Loan Forgiveness Isn’t Free

If you thought that student loan forgiveness is free, guess again.

There’s a hidden cost you need to know about – and it could cost you significantly.

Here’s what you need to know.

Student Loan Forgiveness: The Basics

According to Make Lemonade, there are more than 44 million borrowers who collectively owe $1.5 trillion in student loan debt in the U.S. alone. The average student in the Class of 2017 has about $39,000 in student loan debt.

If you have student loan debt, you have likely considered several options, including student loan refinance, student loan consolidation, student loan repayment plans and student loan forgiveness.

“How can I get my student loans forgiven?” is one of the most popular questions asked at Make Lemonade.

There are several ways to receive student loan forgiveness, including Public Service Loan Forgiveness and Teacher Student Loan Forgiveness. If you don’t work in public service or as a teacher, however, you can still receive student loan forgiveness through certain income-driven student loan repayment plans.

Here’s how they work.

Income-Driven Student Loan Repayment Plans

Today, the standard federal government student loan repayment period is 10 years. For those borrowers who cannot afford their monthly student loan payments, the U.S. Department of Education created income-driven repayment plans in 2007 to help make federal student loan payments more affordable than the standard 10-year plan.

Under the Pay As You Earn (PAYE) income-driven repayment plan, for example, you pay 10% of your discretionary income each month toward your federal undergraduate student loans for 20 years, at which point any remaining balance on your federal undergraduate student loan is forgiven.

Under and Revised Pay As You Earn (REPAYE) repayment plan, if you have graduate school student loan debt, the repayment period is 25 years before your remaining student loan debt is forgiven.

Income-driven repayment plans only apply to federal student loans (not private student loans or Parent PLUS Loans). You can sign up for student repayment plans at studentloans.gov.

There are approximately 7 million borrowers who collectively owe $389 billion of student loan debt in income-driven student loan repayment plans. This includes 1.2 million borrowers who owe $68.3 billion under PAYE and 2.0 million borrowers who owe $108.8 billion under REPAYE.

The Potentially Huge Hidden Cost Of Student Loan Repayment Plans: Taxes

On its face, student loan forgiveness might seem like a no brainer. However, let’s take a closer look.

Under current student loan repayment plans, if you have a remaining student loan balance at the end of your repayment period, then you may be required to pay ordinary income tax on any student loan amount forgiven.

Therefore, your student loan debt is not completely forgiven. Rather, your education debt is exchanged for tax debt.

The result: a potentially massive, one-time tax bill for millions of Americans who collectively could owe billions of dollars in taxes on forgiven student loan debt.

The amount of taxes owed depends on your income tax rate and outstanding student loan balance at the time of forgiveness.

According to the Wall Street Journal, citing an Obama Administration budget estimate, the average student loan borrower enrolled in an income-driven repayment plan could have $41,000 of student loan debt forgiven.

At a hypothetical 30% income tax rate, a borrower with $41,000 of student loan debt could (setting aside any potential tax deductions or credits) would owe more than $12,000 in federal income taxes.

If, however, you receive student loan forgiveness under the Public Service Loan Forgiveness program, you are not taxed on any student loan amount forgiven.

The Benefits and Risks of Income-Driven Repayment Plans

There are benefits and risks to income-driven repayment plans.

The benefit: you save money upfront from lowering your monthly student loan payment or extending the repayment period.

The risk: you will pay more interest over time because lower monthly payments means you are reducing less principal each month. You also may be required to pay ordinary income tax on the loan amount forgiven.

Student Loan Forgiveness & Taxes: Key Questions

1. What if a borrower who receives student loan forgiveness cannot afford to pay income taxes?
2. What is the penalty for failing to pay income taxes on student loan debt forgiveness?
3. If a student loan borrower who receives student loan debt forgiveness does not pay income taxes on the amount forgiven (or if the income tax requirement is modified or eliminated), are other taxpayers collectively expected to foot the bill?
4. If income-driven repayment plans are modified or eliminated, are borrowers currently enrolled in these student loan repayment plans grandfathered in when it comes to student loan forgiveness?

Student Loan Forgiveness: What To Watch For

1. Remember, you may owe income taxes on the student loan amount forgiven.
2. The less you pay each month under an income-driven repayment plan means that more interest is accruing.
3. If you use an income-driven repayment plan to “save money”: remember #1 and #2

Zack Friedman is Founder & CEO of Make Lemonade, a personal finance comparison site. Follow Zack on Twitter. Read his Forbes columns. Contact Zack for speaking engagements. 

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