If student debt relief passes, will loan forgiveness wipe out your tax refund?

This story is part Taxes 2022CNET’s coverage of the best tax software and everything you need to file your return quickly, accurately and on time.

Currently widespread remission of federal student loans remains on hold, awaiting a decision from a federal appeals court. But if debt relief materializes, will you end up with a tax bill in 2023?

Although you don’t owe federal tax on any canceled student debt through 2025, thanks to a provision inserted into the $1.9 trillion from the American Rescue Act’s COVID relief programyou could end up owing state and county taxes.

Whether you receive a rebate under the federal student loan forgiveness plan, Cancellation of civil service loans or another program, your tax liability is the same. 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.

How are canceled student loans taxed?

Although federal taxes on canceled student debt are temporarily suspended until 2025, generally canceled school loan balances are taxed as income. This means that if you receive student loan forgiveness, this amount will be added to your adjusted gross income (the amount you earned last year less any eligible tax deductions). So if you earn $50,000 a year and qualify for $20,000 in debt relief, your income will be adjusted to $70,000 for the year.

States and counties also tax canceled student debt as income.

These States Currently Tax Canceled Student Debt

Most states will not impose taxes on forgiven student loan balances, but a handful will. Right now, we know that Indiana, Minnesota, Mississippi, and North Carolina are all planning to make student loans tax-free.

And two other states, Arkansas and Wisconsin, may follow suit, but have yet to confirm their tax plans.

How much will state and county taxes 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 and local tax rate. Some states have flat tax rates, while others have graduated tax rates, where you pay a higher rate if you’re in a higher tax bracket.

Both Indiana and North Carolina have flat tax rates (3.23% and 4.99%, respectively). Mississippi has a progressive income tax rate, ranging from 3% to 5%, and Minnesota’s progressive tax rate ranges from 5.35% to 9.85%.

If you get student loan forgiveness in Indiana, for example, you can expect to pay $323 in state taxes for $10,000 in debt relief and $646 in state taxes. for $20,000 back.

County taxes may also apply in some states and may be flat or graduated. For example, in Indiana, residents of the capital Indianapolis pay 2.02% Marion County income tax. That means borrowers who receive $10,000 in forgiveness will owe an additional $202 in local income tax, and those who receive $20,000 in debt relief will owe an additional $404. In total, that means a borrower in Indiana could owe up to $1,050 in state and county taxes on canceled student loans.

These states do not tax canceled school loans

According to Mark Kantrowitz of The College Investor, 28 states, plus Washington DC, either have no income tax (and therefore would not tax canceled student loan debt) or automatically comply with federal law and do not will not tax this canceled debt. 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, such as Hawaii, recently announced that canceled student loan debt would not be taxed at the state level. Spokespeople from Virginia, Idaho, New York, West Virginia, Pennsylvania and Kentucky also told The Associated Press that their states will 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.

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 American 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 recover money for eligible education expenses through the 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 affect 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.

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