Student loans: here’s who can pay taxes on canceled student debt

If you are eligible for President Joe Biden widespread remission of federal student loans plan, you may be wondering if you will have to pay taxes on your forgiven debt. The answer? It depends.

Although you owe nothing to the IRS – a provision enshrined in the $1.9 trillion from the American Rescue Act’s COVID relief program passed March 2021 eliminates federal taxes on canceled student loan debt through 2025 – you may owe state or county taxes.

Whether you receive a rebate under the federal student loan forgiveness plan, Cancellation of civil service loans or another program, here’s everything you need to know about how your student loans affect your tax bill. We’ll also share some tax deductions to help you lower your tax bill or increase your refund next year.

Some states tax canceled student debt

The majority of states do not impose taxes on forgiven student loan balances. However, some states do not currently comply with the provisions of the American Rescue Act to prevent the taxation of canceled student loan debt until 2025. As a result, some states may tax canceled debt.

Right now we know Indiana, Mississippi and North Carolina all plan to make student loans tax-free. And three other states may follow suit, but have yet to confirm their tax plans:

  • Arkansas
  • Minnesota
  • Wisconsin

These States Won’t Tax Your Canceled School Loans

There are 28 states, plus Washington DC, that have no income tax (and therefore would not tax canceled student loan debt) or automatically comply with federal law and will not tax such debt cancelled, according to Mark Kantrowitz of The College Investor. These include:

  • Alaska
  • Connecticut
  • Delaware
  • Florida
  • Illinois
  • Iowa
  • Kansas
  • Louisiana
  • Maryland
  • Massachusetts
  • Michigan
  • Missouri
  • Montana
  • Nebraska
  • Nevada
  • New Hampshire
  • New Mexico
  • New York
  • Ohio
  • Oklahoma
  • Rhode Island
  • South Dakota
  • Tennessee
  • Texas
  • Utah
  • Vermont
  • Washington
  • washington d.c.
  • Wyoming

Other states that do not automatically comply with the federal provision, like hawaii, recently announced that canceled student loan debt would not be taxed at the state level. Spokespersons in Virginia, Idaho, New York, West Virginia, Pennsylvania and Kentucky also told the Associated Press their states would not tax borrowers on canceled student debt.

Although California could technically tax canceled student debt, lawmakers said residents would not be taxed on canceled student loans. California State Assembly Speaker Anthony Rendon confirmed in a tweet that the state is ready to take action to stop Californians from paying taxes on canceled debt — and will once details of the federal student loan forgiveness program will be finalized.

At this time, it is unknown what will happen in the states not mentioned, but we will keep you updated as the situation develops.

Here’s How Much State Taxes Could Cost You

If you live in a state that will impose student loan tax forgiveness, the amount you will owe will depend on your state’s tax rate.

In Indiana, for example, the state tax rate is 3.23%. This means that residents who receive $10,000 rebate can expect to pay $323 in state taxes, while those who receive $20,000 rebate will owe $646 in state taxes.

And in some states, county taxes may also apply and increase your tax bill. For instance in indianaresidents of Marion County in Indianapolis will still owe 2.02% in taxes ($202 for $10,000 debt forgiveness and $404 for $20,000).

Other tax considerations for those with student loans

In addition to student loan forgiveness optionsyou may be eligible for tax credits and deductions. Although the 2023 tax thresholds have yet to be released, here are some student loan tax breaks that could increase reimbursement next year or reduce your tax bill.

Student loan interest deduction

When you make monthly payments on your student loans, this includes your principal payment plus any accrued interest payments. Whether you have private or federal student loans, the student loan interest deduction allows you to reduce your taxable income, depending on the amount of interest you paid. For 2021, this reduction has increased to $2,500 per year.

You are eligible for the deduction if you paid interest on a student loan in the particular tax year and you meet the modified adjusted gross income requirements (your income after taxes and allowable deductions). For 2021, you qualify if your MAGI was less than $70,000 (or $100,000 if you are married and filing a joint application). Partial deductions were offered for those with MAGI between $70,000 and $85,000 ($100,000 – $170,000 for those who filed jointly).

With federal student loan payments on pause and interest at 0%, you may not have paid any interest in the past year. That said, you must log into your student loan portal and verify Form 1098-E for any qualifying interest payments.

If eligible, this deduction will reduce your taxable income, which could reduce the amount you owe the IRS or increase your tax refund. You could even be placed in a lower tax bracket, which could entitle you to other deductions and credits
.

US Opportunity Tax Credit

The US Opportunity Tax Credit is available to new students during their first four years of graduate school. It allows you to claim 100% of the first $2,000 of eligible educational expenses, then 25% on the next $2,000 spent, for a total of up to $2,500. If you are a parent, you can claim the AOTC per eligible student in your household, provided they are listed as a dependent.

To claim the full credit in 2021, your MAGI must have been $80,000 or less ($160,000 or less for married people filing jointly). If your MAGI was between $80,000 and $90,000 ($160,000 to $180,000 for those filing jointly), you may be eligible for a partial credit.

The AOTC is a refundable credit, which means that if it reduces your income tax to less than zero, you may be able to get a refund of your taxes or increase your existing tax refund.

Lifetime learning credit

You can get money back for eligible education expenses through Lifetime learning credit. The LLC can help pay for any level of continuing education courses (undergraduate, graduate, and professional degrees). Transportation to college and living expenses are not considered eligible expenses for the LLC.

Unlike the AOTC, there is no limit to the number of years you can claim the credit. You could get up to $2,000 each year or 20% on the first $10,000 of eligible education expenses. However, the LLC is non-refundable, meaning you can use the credit to reduce your tax bill if you have one, but you won’t get any credit back as a refund.

For 2021, you were eligible for this credit if you had qualifying expenses and your MAGI was less than $59,000 ($118,000 for married people filing jointly). You could also claim a reduced credit if your MAGI was between $59,000 and $69,000 ($118,000 and $138,000 for married people filing jointly).

To note: You cannot apply for both AOTC and LLC for the same student in the same tax year. If you qualify for both, the AOTC generally provides greater tax relief (and may increase your refund).

If your loans are in default, will next year’s tax return be seized?

Normally, if you have federal student loans in default (meaning you are unable to pay what you owe for 270 days), your tax refunds can be used to cover the balance owing. Since federal student loans were on pause during the 2022 tax season, your federal tax refund was not eligible for government garnishment.

It’s unclear if this will remain in place for 2023, but with the new payment pause set to expire at the end of 2022, this benefit may expire.

Your tax filing status may affect your student loan payments

If you repay federal student loans and follow an income-based repayment plan, your marital status may impact your payment amount. For example, if you are married and filing jointly, your payments are based on the joint income between you and your spouse. If you are married and file separately, your payments are based on your income only.

However, if you decide to file separately to lower your monthly IDR plan payment, you may miss out on other key tax benefits. For example, you may not be able to take advantage of a lower tax rate given to married couples who file jointly, nor will you be able to claim increased credit and deduction amounts available if you file jointly.

The revised Pay As You Earn, or REPAYE, plan does not distinguish between whether you are listed as married filing separately or married filing jointly. Your payments are based on your income and that of your spouse.

More advice on student loans

Garland K. Long