Student Loan Forgiveness and Your Taxes

Forgiveness. Who the heck thought up such an awful sounding word?

Anyway, this is a post in 2 parts.

• The bill passed by the Senate does not include any student loan forgiveness.
• The bill passed by the Senate does include a provision for a window of 6 years in which student debt, if forgiven later, will not be taxed.

Yeah. It's weird. DM asked after class to explain what was up with the second point.

What is student loan forgiveness? It means that the government is going to pass a law that you don't have to pay back your loans. No one is proposing that this be 100%. Usually, some fixed amount like $10K or $50K is tossed around.

Can the government actually do that? Well, yeah, they probably could. Here's the thing that just about no one who voted for the Democrats this year because of student loans was thinking about: the loan is still someone else's money, so if you don't have to pay it back, the government is asserting that it will do so on your behalf. Of course that will put upward pressure on taxes, or downward pressure on spending. Pick your poison. I suspect that people would not be as jazzed about student loan forgiveness if it was paired with sending smaller social security checks to grandma.

Is student loan forgiveness a decent idea? I hate to rain on your parade, but it's about the economically dumbest idea politicians have ever come up with. (In fact, it was called exactly that by Justin Wolfers, a prominent progressive economist). The reasons are pretty simple: 1) college is an investment, you're the only one getting the reward so you should pay the costs, 2) there is very little quality control about what students actually get out of those investments, and debt forgiveness rewards poor choices, and 3) most people don't go to college and there's a strong tendency for people who are affluent to begin with to end up there.

Here's the nasty part. Debt forgiveness is considered to be income by the IRS. So it is taxable.† It gets worse. Debt forgiveness is counted completely in the year in which the debt is forgiven. So it can also bump you into higher brackets where more tax is collected. Here's an example:

• Prior to student debt forgiveness, you are a poor alum in a lousy job making $22,400 per year. You take the standard deduction of $12,400, leaving $10,000 to be taxed mostly in the 10% bracket. So you owe roughly $1,000. Not fun, but doable.
• Now, with student loan forgiveness of, say, $50,000, your income pops up for one year to $72,400. You take the standard deduction to get down to $60,000. But the way that brackets work is that you 10% of the first $10,000, plus 12% of the rest up to $40,000, plus 22% of anything past that. That is, $1,000 + $3,600 + $4,400 = $9,000. And until you work out a payment plan, you owe 9 times as much in tax, all at once, in cash. That's a big problem.

Back to the political wackiness. Forgiving student loan debt is not that popular with politicians because they know how screwy an idea it is. BUT, it's in the Overton Window this year, and if they pass it they might get re-elected. However, they did not put it in the proposed stimulus package because they do not have the votes to pass it, and didn't want it to be the reason the whole bill is voted down. 

Instead, they fixed the taxation of student loan forgiveness in case they get the votes to pass it in the future.

Except there's a problem (two actually ... the second is that I read up about this point about 2 months ago, and I can't find the cite right now). Anyway, it's likely that student load forgiveness would be ruled unconstitutional. I can't recall the argument, but I think it was along the lines that if the government didn't make the loan, it doesn't have standing to change the law governing the loan after it's made. Since all student loans are made through private entities (even when they say automatic federal loan), this would seem to be a dealbreaker. Of course, in sports and politics, the usual strategy is to break the rule first, and then see if a foul is called.

† Personal story added for emotional valence. I will be dealing with this on my family's taxes. My son broke his arm up at the U 18 months ago. And, while it was covered by insurance, the out-of-pocket expenses ran to a few thousand dollars. I told my son to pay them, and we would see about helping him out (sounds harsh, but he'd already tapped deeply into us for money that year, so we all agreed it was sensible). But COVID ‡ He lost his job, he was paying rent on an apartment he wasn't living in, and so on. You get the drill. So I picked up the payments (and like a dummy had my name put on the account), but in short, we still owed until about 3 months ago when the University Hospital forgave a lot of outstanding medical debts (presumably to be COVID sensitive during the holidays). It was not a ton of money: under $1,000. Here's the thing. It's debt forgiveness so it's taxable income at both the state and Federal levels. Further, since it is an addition to my income, the marginal rate that applies to it is the highest tax bracket that applies to our household. So I'll have to give almost half of it back, all at once, even though I had a string of small upcoming payments that would not have been hard to pay.

‡ Personal story added because it's made other students laugh. We have a cute saying in our household: "plague rules". It means something is being done differently because 2020-21 has just not been normal or OK. In this case, plague rules means I was paying the medical bill, even though I was not riding the Bird (while bummed out and late) when it crashed.