This post is part one of a multi-part series on repaying student loans and the unexpected costs and considerations.
Students expect the income they will receive after graduation will prove sufficient to make a living and repaying student loans will be straightforward. Sometimes this expectation becomes reality. Sometimes it does not.
As of 2017, more than two million borrowers have individual student loan debt that exceeds $100,000. For the millions more who have lower student loan balances, many have lopsided debt-to-income ratios. It is no wonder that few borrowers can pay student loans in full under the standard repayment plan.
Alternative student loan repayment plans permit a borrower to repay his loans at a reduced rate based on his income. Three common examples include the Income-Based Repayment Plan (IBR), the Pay As You Earn Repayment Plan (PAYE), and the Income-Contingent Repayment Plan (ICR). These attractive options permit borrowers to repay what they can while maintaining an acceptable standard of living.
More than that, these programs include loan forgiveness. For example, under IBR, PAYE, and ICR, any outstanding balance may be forgiven after 20 or 25 years of repayments. This loan forgiveness is the light at the end of the tunnel.
After 240 to 300 monthly student loan payments, the former students will be free from student loan debt. The freedom may be short-lived. The student loan debt forgiveness may trigger large tax liabilities.
Discharge of Student Loan Debt Generally Is Part of “Gross Income”
The general definition of “gross income” under the Tax Code includes “[i]ncome from discharge of indebtedness.” In most cases, discharge of student loan debt is no exception to this definition. For this reason, the amount of student loan debt forgiven will be counted as gross income for the tax year in which the debt is forgiven, and the amount will be subject to income taxes. Depending on his financial situation, the additional tax liability can be overwhelming for the borrower.
Example #1: An Average Example
Let’s consider one of the two million borrowers with student loan debt totaling at least $100,000. Assume he borrows exactly $100,000 at a 4.29% interest rate. He graduates and obtains employment with a salary of $50,000. His monthly student loan payment is probably $1,027 under the standard repayment plan. If he can afford to make the monthly payment for 10 years, he will have paid off his student loans in 10 years at a total cost of $123,212. Since he has paid off his loans and no balance remains, there will be no forgiveness of debt and thus no corresponding taxable income for the final year.
However, considering the cost of living, payroll deductions, healthcare, and other expenses, the borrower may not be able to afford this monthly payment. He turns to one of the repayment plans. He decides to enroll in Income-Based Repayment for New Borrowers. This lightens the load per month. His IBR monthly payment starts out at $268 and, by the end of his 240 payments, his last payment is $823. Because of interest, the outstanding balance on his student loan debt after twenty years of repayment is $58,511. This amount will be forgiven but he will have to report to the IRS the $58,511 as part of his gross income that year. Now he will owe income taxes on $58,511.
Example #2: Another Realistic Example
Slightly altering the above example, if the individual is one of the almost half million borrowers whose student loan debt exceeds $200,000, the situation will be much worse. Doubling the amount incurred in the previous example, let’s say he takes on $200,000 in student loan debt. Under IBR, after 20 years of repayments, the projected loan forgiveness would be $251,230. The forgiveness would exceed the amount originally borrowed because his income-based payments would not be enough to cover even the interest that accrued on the loan. Accordingly, he would need to report to the IRS an additional $251,230 as part of his gross income for the year the amount was forgiven.
Clearly, these examples are oversimplified given that this borrower may get salary raises or a better paying job during the twenty years of repayment, which will improve (or possibly even avoid) the eventual tax problem. On the other hand, for example, his income may remain stagnant, or he may lose his job and be unable to find another job at that level of income. In any event, even though he is now free of student loan debt, he has a new debt to the IRS that he must address.
The additional tax liability resulting from the loan forgiveness in the examples above is substantial. For the sake of simplicity, the following examples will use 2016 tax year rates and will not take into account deductions, tax credits, additional potential income, state taxes, or other factors that may come into play. Our borrower is also single, at least for this pretend tax year.
In Example #1 the borrower has an estimated tax liability of approximately $8,278 for his $50,000 salary. Combined with the student loan debt forgiveness of $58,511, he has gross income of $108,511. Accordingly, his estimated tax liability rises to approximately $23,419.83. The student loan debt forgiveness cost him approximately $15,141.83 extra in tax liability, which he now must pay.
The tax liability is much bleaker for the borrower in Example #2. Again, based on just his salary, the borrower would have had an estimated income tax liability of approximately $8,278. Combining his salary with the loan forgiveness amount of $251,230, his gross income for the loan forgiveness tax year becomes $301,230. His estimated tax liability thus skyrockets to approximately $82,935.15. The additional tax liability resulting from his student loan forgiveness in this example is $74,657.15.
In both situations, the tax liability in effect extends the financial burden on the student loan borrower beyond the repayment period that students anticipate when they incur the loans.
Each student taking on debt should learn what awaits them at the end, including potential tax consequences. Borrowers may pay what they can while pursuing their dreams. Programs to help borrowers by permitting reduced monthly payments corresponding to income will not completely help the borrower whose income does not significantly increase during the repayment period. These programs include debt forgiveness of unpaid balances. But for the borrower whose income has remained stagnant, large tax consequences will strike from the debt forgiveness. These taxes will fall upon the borrower with the least means to pay them. All borrowers beware before incurring student loan debt.
About the Author
Caleb Chaplain is the career law clerk for the Honorable Rebecca B. Connelly, Chief United States Bankruptcy Judge for the Western District of Virginia. Previously, he served as a term law clerk for both Judge Connelly and the Honorable Paul M. Black, United States Bankruptcy Judge for the Western District of Virginia. He graduated from Dartmouth College with a B.A. in Classical Language and Literature in 2007 and received his J.D. from Indiana University Maurer School of Law in 2013.
 Zak Friedman, Student Loan Debt in 2017: A $1.3 Trillion Crisis, Forbes.com (Feb. 21, 2017, 7:45 AM), https://www.forbes.com/sites/zackfriedman/2017/02/21/student-loan-debt-statistics-2017/.
 The debt-to-income ratio is the amount of a monthly debt payment divided by monthly income.
 Under standard repayment plans, students typically pay off their student loans in 10 years (120 monthly payments) or less.
 26 U.S.C. § 61(a)(12).
 The average interest rate for the 2015-2016 school year for undergraduate students obtaining direct federal subsidized and unsubsidized loans was 4.29%. Susannah Snider, 3 Facts to Know About the New Student Loan Interest Rates, U.S. News & World Report (July 1, 2015, 9:00 AM), https://www.usnews.com/education/best-colleges/paying-for-college/articles/2015/07/01/3-things-to-know-about-the-new-student-loan-interest-rates.
 According to the National Association of Colleges and Employers, the median salary for a bachelor’s degree in business, from a sample of 4,922 individuals graduating in 2015, was $50,000. Average Starting Salary for Class of 2015 Climbs 5.2 Percent, Nat’l Assoc. of Colls. & Emp’rs (Nov. 18, 2015), http://www.naceweb.org/s11182015/starting-salary-class-2015.aspx.
 All of the amounts of repayment in this article are derived from the “Repayment Estimator,” available on the Federal Student Aid website at https://studentloans.gov/myDirectLoan/repaymentEstimator.action.
 See Friedman, supra note 2.
 The following tax amounts are derived from the 1040 Tax Tables for 2016 published by the Internal Revenue Service.