Student Loan Forgiveness: Tax and Interest Consequences

Average student loan debt has reached more than $27,000, documents the Los Angeles Times. That can prevent graduates from buying those big-ticket items such as houses and new cars, which help grow the GDP. Therefore, there has been ongoing legislation to ease the burden on these debtors. Pending is the Student Loan Fairness Act. If that passes, the provisions could provide new terms and conditions for repaying this debt.

Right now debtors have a number of options for making their debt more manageable on a month-to-month basis. Essentially, those options fall into two categories. One is the Income-Based Repayment (IBR) program and the other is the Public Service Loan Forgiveness (PSFL) program. Both result in “loan forgiveness” after a set period. However, one – IBR – results in a tax liability for that debt forgiveness, just as happens with other kinds of debt forgiveness such as credit card debt. Those who select the IBR and the newest version of it – Pay as You Earn – should be aware of the tax consequences, both federal and state. In addition, because of the extended period for repayment from the original 10 years, overall interest paid out could total a higher amount than it would have under the standard terms and conditions.

With IBR, federal loan monthly repayments are adjusted according to the debtor’s income over a 25-year period. Therefore, only those with relatively low income would apply. Typical among applicants are those who attended law school, accumulated six-figure student loan debt, and may not have been able to get a position practicing law. For example, they might be working as journalists on in Manhattan, making significantly less than the usual entry-level compensation of $160,000 for a Manhattan law firm. The new version of IBR – Pay as You Earn – can provide an even lower monthly payment over 20 years. After that, for both, there is loan forgiveness.

With PSFL, those employed in jobs classified as public service pay monthly the designated original amount due on loans. But after 10 years the balance is forgiven, without any tax liability. Those professions typically include teaching and child care. The eligibility rules are strict, such as documentation of full-time employment and on-time payment. For that reason, those considering this option should review the terms and conditions with Federal Student Aid, an office of the U.S. Department of Education.

Unless there is new legislation, after 25 or 20 years, those who opted for versions of IBR will face a tax liability, federal and perhaps also state. After 25 years, estimates the Institute for College Access & Success, the married engineer with one child and $60,000 in student loans could have a federal tax liability of $5,801 or the equivalent of $1,417 in 2013 dollars. The amount forgiven would be $23,202.

In addition, as those know who have had any kind of debt repayment extended over a period of time longer than the original terms and conditions, the amount of interest paid could be larger. That would make the overall cost of the loan larger. If the engineer had stuck with the original 10-year repayment plan, the total payout, including interest, would have been about $82,858. Under a 25-year schedule, the amount paid in would be about $124,935. That is, the repayment equaled the principal of $60,000, plus about $63,241 in interest.

Therefore, as with all decisions about how to repay debt, those with student loans have to consider if the standard terms and conditions would be a better financial choice. Instead of opting for other options, they would bring in more income and cut back on fixed expenses so that they could pay off the loan in 10 years.