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Heads up! You could be taxed on student loan forgiveness

February 23, 2023
4 minutes

Owing taxes on your loan forgiveness

You read that correctly. Based on where you live in the U.S., you may be obligated to pay taxes on forgiven student loans that fall under the government's student loan forgiveness plan. Before you get too excited about the prospect of forgiveness, it's crucial to understand if you are liable to pay taxes on the sum of your forgiven loan amount.

Usually when debt is forgiven, it must be declared on your taxes. Fortunately, for student loan forgiveness, there is no federal tax burden upon this event. States, however, may require taxes owed on the forgiven sum.

So which states could pose taxes on federally forgiven student loans?

  • Arkansas
  • California
  • Indiana
  • Minnesota
  • Mississippi
  • North Carolina
  • Wisconsin

While some states may consider forgiven student loan debt as taxable income, there are exceptions that can provide relief. For instance, Pennsylvania and New York have passed laws exempting student loan borrowers from taxation on forgiven debt.

How much can you be taxed on forgiven student loans?

When it comes to taxation on student loan forgiveness, the tax rate you will be subject to is determined by your state's income tax system. For instance, if you live in a state with a progressive income tax system, each tier of your income would be taxed at an increasingly higher marginal rate. For example, if you made $40,000 a year in taxable income, the first tier of income ($0-10,000) would be taxed at the lowest rate of 5%, while the second tier (10,001 to 20,000) and third tiers (20,001 - 30,000 and 30,001 - 40,000) would be taxed at an increasing rate of 8% and 11%, respectively. Thus it is important to research what your state's department of revenue services tax brackets are before considering student loan forgiveness.

Additionally it is important to note that the total amount forgiven will not necessarily equate directly with taxes owed; rather the amount forgiven must first be added to your taxable income for that year and then taxed accordingly as detailed above. This means that depending on other deductions or exemptions that you may have claimed throughout the year it is possible that you could owe substantially more or less than expected when all is said and done. It is thus recommended to thoroughly assess each part of your financial status prior to proceeding with student loan forgiveness.

As part of your income, your federal student loan forgiveness balance can have an effect on the amount of taxes you owe. If you had $10,000 of forgiven loans added to the original amount of $40,000 in taxable income, your tax rate would only increase to a maximum of 7%. This means that even with the additional forgiven loan money added to your taxable income, it may not be enough to push you into a higher tax bracket. However, it can still result in an increased tax bill due to the extra amount now being included in the total taxable income. For example, if you were taxed at a rate of 7% on the original $40,000 before the additional loan forgiveness was applied, then with the addition of $10,000 you would now owe a total of $2,550 in taxes - taking into account both amounts. It is important to remember that while student loan forgiveness can be beneficial in some ways as it can reduce some or all of what is owed on student loans; it should not be taken lightly as it could potentially lead to more taxes owed when filing returns.

Example of student loan forgiveness tax burden

If you are eligible for federal student loan forgiveness but also live in a state that may tax your forgiven amount as income, you may be feeling uncertain about how to weigh the two options. But doing some basic calculations can show you why student loan forgiveness is still an excellent choice in spite of any taxes that may apply.

For example, if the forgiven amount is $10,000 and it is from a loan with a 5% interest rate and five years remaining on the repayment period, then you would save more than $1,300 in interest costs by opting for the loan forgiveness even after paying taxes on the forgiven debt. In this case, if the income tax rate were 10%, then you would pay $700 now in taxes but still end up saving around $10,600 thanks to student loan forgiveness.

It's important to remember that states have different policies regarding taxation of forgiven debt. Some may choose to make an exception for student loan debt, so it's important to stay informed about changes in your state's tax laws and consult with your tax preparer or state tax board if necessary. It will help you ensure that you get all the benefits available under federal student loan forgiveness programs while minimizing problems related to taxation.

Source: Experian

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