Out of the fire and into the frying pan: Borrowers can face a huge tax bill after finally getting student loan forgiveness. It is often called the student loan tax bomb.
The good news is that this hefty tax is often avoidable.
Unfortunately, not all borrowers will dodge the student loan tax bomb. This is a significant downside to forgiveness and something any borrower applying for loan forgiveness should understand.
Origins of the Student Loan Tax Bomb
The origins of the large pardon tax bill can be traced to a single IRS rule.
In many cases, this rule makes sense. If I work for Visa and Visa chooses to forgive my bonus credit card debt, it is fair to tax that discount as income.
Likewise, it would not be fair for employers to “loan” their employees’ money every week and “forgive” it later to avoid taxes.
Student loan forgiveness is not taxed – for now
The good news for many borrowers is that student loan forgiveness is a notable exception to the rule requiring forgiven debt.
Unfortunately, this particular exception ends on January 1, 2026 for many types of student loan forgiveness. In other words, if you reach IDR forgiveness before 2026, you are in the clear. If you make payments on the SAVE plan through 2029, there could be a large tax bill in your future.
PSLF special exception: Unlike the IDR rebate, the PSLF duty-free rebate is permanently enshrined in the tax code.
If you expect to get a rebate from the PSLF in 2030, there won’t be a huge pending tax bill.
Periods after 2026 and planning for the worst
Effective January 1, 2026, the temporary rules expire. At this point, the rebate under income-driven plans like SAVE and IBR is taxed.
Although 2026 may seem a long way off, many borrowers don’t expect to get forgiveness before then.
For this reason, it is crucial to anticipate the possibility of a large tax bill.
As a borrower who does not expect debt relief until 2026, I use a Roth IRA to plan my tax bill. If I get a tax bill, I’ll have money saved and ready to go. If I’m not taxed, I have extra money for retirement.
Those who don’t want to be fancy can also use a high yield savings account. With interest rates currently starting around 5%, the money set aside for a possible tax bill has room to grow.
Debt cancellation rules set to change
Even though student loans have become a politically charged topic, there are some areas where both sides seem to agree.
Taxing loan forgiveness is one area. Without bipartisan support, the temporary rule eliminating the tax until 2026 would never have passed.
I would say that parents with Parent PLUS loans have the most compelling argument against tax relief.
Under the Parent PLUS rules, parents are protected in the event of a tragedy. If the child for whom the loan was borrowed dies, any remaining Parent PLUS debt is forgiven.
Before the tax rule changed, these parents were hit with large tax bills. It was both a tragic and unfair result.
While it is difficult to predict the future and especially difficult to predict where the political winds might be blowing, I would expect the loan forgiveness tax to eventually become permanent eliminated.
How to Calculate Your Student Loan Forgiveness Tax Bill
Projecting a possible student loan exemption tax bill is a tricky business.
To begin with, we do not know whether this tax will exist or not.
If we assume the worst, we still don’t know what tax brackets will look like in such a distant future. Moreover, it is almost impossible to project income far into the future.
In 2023, tax rates ranged from 10% to 37%. If you were taxed on $1,000 of rebate in 2030 and the tax rates remained the same, you would owe the IRS between $100 and $370.
Borrowers with the largest loan balances could face tax bills of over $100,000!
State taxes on federal loan forgiveness
Federal taxes aren’t the only issue borrowers need to consider when considering the financial impact of loan forgiveness.
Many states follow IRS rules on loan forgiveness. In these states there is no tax, but it changes in 2026.
Other states do not follow IRS rules on income determination. Some of them currently charge borrowers a tax on canceled debt.
For this reason, borrowers who successfully obtain student loan forgiveness may withdraw. For some, the potential state tax bill is unaffordable and withdrawing the relief is the only option.
Tax rules to avoid the massive bill
In the IRS rules, there is a massive exception to the canceled debt tax.
Some states may offer a similar rule.
For planning purposes, this is another situation where planning for the worst and hoping for the best is the right approach. Don’t assume you can avoid tax via the insolvency exception until you get the go-ahead from an accountant.
Sherpa Tip: Because there are federal and state tax laws to consider, it’s a great idea to speak with an accountant if you’re about to forgive.
A good accountant can help you understand the latest developments in tax law and minimize the tax bill.
If you have a large debt that is about to be forgiven, talking to an accountant could be money very well spent.
Minimize IDR Remittance Tax Bill
The longer the debt is forgiven, the greater the potential tax consequences.
For borrowers with large balances and lower monthly IDR payments, their balance may increase each month.
In these circumstances, the new SAVE plan is an excellent option to reduce the tax bill. With the SAVE package, borrowers receive a generous grant to keep the balance from growing.
Those who qualify for $0 payments per month have an effective interest rate of 0% on the SAVE plan.
The SAVE plan will help borrowers prevent their balance from growing. Once these borrowers get the forgiveness, the amount forgiven will be less and the potential tax bill will be more affordable.