How Biden's student loan forgiveness could blow up your tax bill

Even if your student debt is on pause right now, you’re probably wondering how you'll deal with it again when it returns. What if someone could just snap their fingers and make all of it go away?

Well, that’s not exactly the plan proposed by President-elect Joe Biden, but the incoming commander-in-chief and a vocal group of backers have floated the idea of canceling thousands of dollars in student debt per person.

That would make a huge difference in the life of someone who’s lost work during the pandemic.

However, even if the current plans do come to fruition, they won’t eliminate everyone’s debt — and they may come with a gargantuan “tax bomb” for you. Here’s what you need to know.

How much debt could be forgiven?

Americans currently hold more than $1.7 trillion in student debt, according to the Federal Reserve. Yet the pause on payments and interest is scheduled to end in February, even as COVID-19 cases pile up across the country.

Biden has already said he supports legislation that would “immediately” forgive $10,000 in federal student debt per person.

Borrowers are in “real trouble,” Biden said during a November news conference. “They’re having to make choices between paying their student loans and paying their rent, those kinds of decisions.”

But is $10,000 enough? A group of prominent Democrats, led by Sen. Elizabeth Warren and Senate Minority Leader Chuck Schumer, say no.

They want the Biden administration to cancel up to $50,000 in debt as a form of economic stimulus, allowing people to start buying homes and investing for retirement.

What will actually happen?

On top of that immediate aid, several other measures are in the works to reduce Americans’ student debt, including improvements to the government’s income-based repayment program and Public Service Loan Forgiveness Program.

The big problem, of course, is that all of these measures would be extremely expensive. Biden may fail to pass them if Republicans control the Senate after two Georgia runoffs in January.

Some backers argue the incoming president can use an executive order to cancel debt under the 1965 Higher Education Act, but that could lead to the first major legal battle for the new administration.

Biden could also try to pass a watered-down, bilateral solution. A new deal may only target borrowers who are in serious economic distress — and it may not be tax free.

Tax bomb incoming?

Normally, you need to pay income taxes on the balance of canceled debt, as if you “earned” it in cash. That means Americans benefiting from tens of thousands in loan forgiveness could face an enormous bill at tax time.

Goldman Sachs suggests that borrowers may be on the hook for as much as 20% of the amount forgiven, Forbes reports.

In his platform, Biden vowed to amend the tax code to make forgiveness through the income-based repayment program tax free, saying “Americans shouldn’t have to take out a loan to pay their taxes when they finally are free from their student loans.”

While Schumer is calling for those amendments to extend to all student loan forgiveness, you’ll definitely want to start saving up, just in case. If you can’t afford your tax bill right away, the IRS will begin charging you interest and fees.

What are your other options?

It’s crucial to recognize that these forgiveness proposals only apply to federal student loans, not the private loans obtained from banks and other nongovernment lenders.

So if you have a private loan — or if you don’t think Biden and his supporters will get their way — you’ll have to pursue other options.

Fortunately for you, interest rates on private student loans have dropped big-time during the pandemic. Borrowers with either federal or private loans should consider refinancing — that is, trading your old loan for a new one at a much lower interest rate.

It’s true that switching from a federal student loan to a private one would make you ineligible for any government relief in the coming months. That could be a tough call to make.

However, there's no downside if you already have a private loan. Refinancing now while rates are cheap could significantly reduce your monthly payment, saving you thousands and allowing you to pay off the balance years sooner.