Congress Makes Big Change To Income-Based Repayment: What Student Loan Borrowers Should Know - Forbes

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The Senate on Saturday approved President Biden’s massive $1.9 trillion stimulus package. Included in the legislation is a small but major tweak to student loan law that could have significant impacts on student loan borrowers who are repaying their loans under income-driven repayment plans.

Specifically, a provision of the stimulus legislation temporarily exempts student loan forgiveness from federal taxation. This has major implications for student loan borrowers who expect to obtain student loan forgiveness through income-driven repayment plans like Income-Based Repayment (IBR), Income-Contingent Repayment (ICR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE).

Income-Driven Repayment For Student Loans

Income-driven repayment programs are a lifeline to millions of federal student loan borrowers. The term “income-driven repayment” describes a collection of plans that calculate a borrower’s monthly student loan payment based on their income. These plans include Income-Based Repayment (IBR), Income-Contingent Repayment (ICR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE).

While each plan is different, they all function similarly on a basic level. Monthly payments under income-driven plans use a formula based on the borrower’s family size and taxable income (typically their Adjusted Gross Income (AGI) as reported on their federal tax return). Payments are recalculated every 12 months, so as the borrower’s income changes, their payments would change, as well. Importantly, any remaining balance would be forgiven at the end of the plan’s repayment term, which is either 20 years or 25 years, depending on the specific program.

For millions of borrowers, an income-driven repayment plan is the only affordable repayment option. But it comes with a significant catch.

Student Loan Forgiveness Under Income-Driven Repayment

In addition to affordable payments, income-driven plans like IBR, ICR, PAYE, and REPAYE provide for forgiveness of the borrower’s federal student loans at the end of their repayment programs. This is important, because many student loan borrowers would never be able to fully repay their student loans otherwise.

But traditionally, this type of student loan forgiveness is treated as a taxable event. In other words, the balance that gets forgiven at the end of the loan’s repayment term could be treated as “income” to the student loan borrower for tax purposes. This has major ramifications — particularly for borrowers whose payments under an income-driven repayment plan are not high enough to cover interest accrual, which can result in balance growth, even while payments are made.

Here’s an example. Let’s take a single borrower who has a federal student loan balance of $60,000 at a 6% interest rate. Let’s say she has a current and projected annual taxable income of around $35,000 per year (for simplicity, we will assume no major changes to her income over time). Her monthly payment under the Income Based Repayment (IBR) plan would be around $210 per month (as compared to a normal 10-year Standard plan payment of around $660 per month).

That monthly IBR payment is affordable for the borrower. But interest on the balance accrues at $300 per month. So even while the borrower makes payments of $210 per month, the difference — $90 every month — accrues in interest. As a result, the borrower’s student loan balance actually grows over time. After 25 years, that $60,000 balance would instead be $87,000, even though the borrower made $63,000 in total payments. Yes, you read that right — the borrower would have made enough payments to repay more than the original principal in full, but she ends up with a balance even greater than what she started with.

Adding insult to injury, if that $87,000 balance gets forgiven and taxed as income, the student loan borrower could be looking at a massive tax bill. Assuming an effective tax rate of 25%, she may have to pay income taxes of over $21,000 for the year in which her student loans get forgiven. And that would be due all at once, immediately.

Student Loan Forgiveness Tax Is Removed — Temporarily

The Senate stimulus bill’s student loan tax provision exempts student loan forgiveness from federal taxation. This would cover a multitude of student debt cancellation events, including student loans forgiven under income-driven repayment plans. This could remove the threat of the so-called “tax bomb” (as some call it) at the end of the loan repayment terms when the borrower’s student loans would be forgiven. State tax treatment of student debt cancellation may vary.

However, because of the way the stimulus bill had to be passed by Democrats in Congress (through the budget reconciliation process, given broad Republican opposition), the tax relief is only temporary, and is currently scheduled to expire on January 1, 2026.

Relatively few student loan borrowers are expected to get their loans forgiven under these programs between now and then, since most of the income-driven repayment plans are less than 25 years old. The ICR plan, however, was created in 1994, so there will be some borrowers who are repaying their student loans under ICR (or who started off on ICR, and subsequently switched to IBR or REPAYE) who will in fact get their loans forgiven before 2026.

That said, this student loan tax relief is a critical first step. It will provide real relief to some student loan borrowers during the next several years. Moreover, it will put enormous pressure on Congress and the White House to extend this tax relief or make it permanent as more borrowers become eligible for student loan forgiveness under these programs in the coming years. Failure to act by 2026 would effectively result in a tax increase on millions of student loan borrowers — which would be a bipartisan political landmine.

What’s Next?

The bill now heads back to the House for a final vote, which could come as soon as Tuesday. President Biden is expected to sign the bill into law within a week.