Earlier, when a student loan was forgiven, the balance that was forgiven was considered as part of the borrower’s income. The reasoning was that forgiving any debt is similar to giving the debtor money to pay off the loan. The forgiven amount was then taxed because all income is taxable under US tax laws. This resulted in a big jump in the borrower’s income for that year accompanied by a steep hike in the taxes they owed for that year. The large tax bill following student loan forgiveness was commonly known as a student loan forgiveness tax bomb.
If you’re worried about your grad school loan forgiveness and the subsequent tax bomb, you can breathe easy. Taxation on loan forgiveness has been put on hold temporarily.
In March 2021, President Biden signed the $1.9 trillion stimulus bill. As part of this COVID relief package, the student loan forgiveness tax bomb was temporarily suspended until 2025. That means if you get your student loans forgiven any time before 2025, you won’t owe any taxes on the forgiven amount.
This is great news if you’re eligible for student loan forgives within the next three years. Depending on the amount you get forgiven, you could potentially save hundreds or thousands of dollars in taxes.
If you’re eligible for student loan forgiveness, you would have been setting money aside for your upcoming tax bomb. If you receive forgiveness before 2025, you’re not going to need that money. In that case, it’s time to think about how to make the best use of those disposable funds.
The best use of that money would be to pay off your high-interest debts such as credit card debt, private student loans, or mortgage.
If you haven’t established an emergency fund, use the money to start one. It’s important to have one in place to cover those unexpected medical or car repair bills.
If you’ve done all of the above, invest the money in a high-yield savings account.
This student loan forgiveness tax holiday is just temporary. If you receive forgiveness after this provision expenses, you’ll have to pay taxes on the forgiven amount. Depending on how much is forgiven, you could end up with a large tax bill and taxes on forgiven student loans are due in full immediately.
Before you use up the money you’ve set aside, you need to determine your student loan forgiveness date and the estimated amount. This will help you decide what your next steps should be. If your loan forgiveness is not due until after 2025, it’s a good idea to keep setting aside money to cover that future tax bomb.
We hoped you enjoyed this article! Remember, you canand potentially lower your monthly student loan payments and save money.