Tax Repercussions in Student-Debt Relief
This post was written by Audrey Keohane, a Summer Intern here at Woodside Wealth.
In 2007, the Education Department enacted an attractive new way to repay student loans once out of college. This new plan is labeled “income-driven repayment plans.” These plans allow for the college graduate to automatically repay their loans each month using 10% of their discretionary income. After 20-25 years of a private-sector worker making their monthly payments, the remaining balance left on the loan is forgiven. While this plan may seem like a no-brainer to some, it is important to consider the tax implications of this choice.
When the remaining balance on the student loan is relieved, it is considered income for that year and is taxed in the corresponding tax bracket. Most people are not aware that this debt relief will be taxed and won’t be prepared for the bill they will inevitably receive. To get a better idea of what kind of money they will owe, the Obama administration once estimated the average debt that is forgiven in this type of plan is $41,000. With a 25% tax bracket, the tax owed on this “income” is $10,000. To give a more extreme example, the Wall Street Journal recently reported the story of an orthodontist with $1,000,000 in student loans. This person will have to pay over $700,000 in taxes if all his debt was forgiven.
While that example may be a rare case, it is still important to understand the reality of what you may owe in the future. Repayment plans such as this could be considered “balloon payments”- payments that start off small until a giant, one-time payment is due at the very end. Payments like these are risky if you don’t know what you’re getting yourself into.
Overall, if you are choosing a payment plan for student-loans be sure to include the large, one-time payment in your consideration of income-driven plans. If you already on this type of plan, there is no need to worry. As long as you are aware of and can estimate the tax amount to be payed, you can begin saving in a separate account so you will not have to make any sudden expenditures when the time comes. If you understand and are prepared for the large end payment, this plan may be something to look into.