Income-Based Repayment (IBR) Plans can ease the burden of student loan debt by basing your monthly loan payments on your income and family size. After 25 years, whatever amount is left on the loan will be forgiven. The IRS calls this forgiven amount “cancellation of debt” income and taxes it accordingly.
For example, let’s assume you refinance to an IBR loan repayment plan and conscientiously make your IBR payments every month for 25 years. You finally receive notification that the remainder of the debt, let’s say $40,000, will be forgiven. But don’t take out the bubbly just yet: That $40,000 will be included as gross income for the year and will be taxed at your marginal tax rate. So, if you pay a 28% tax rate and are single, you will owe $11,200 in tax on the forgiven debt.
In addition, that $40,000 will be included in your adjusted gross income for the year, likely pushing you into a higher tax bracket. Consequently, you’ll have to pay a higher tax rate on all of your other income as well.
Unless you work out a payment plan with the IRS, this tax will be due in the year the loan was forgiven.
So when you consider refinancing your loans to an income-based payment plan, remember that “There’s no such thing as a free lunch.” In the case of IBR’s, the bill may not come for many years, but it will come nonetheless.
