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What Biden's student loan forgiveness would mean for your taxes

A tax expert weighs in on how Biden's student loan forgiveness plan would affect borrowers' taxes.

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Editor's Note: This post was updated to reflect President Biden signing the American Rescue Plan into law on March 11, 2021, which makes all student loan forgiveness tax-free.

Since President Joe Biden's first day in office, federal student loan borrowers have been eager to see if and when he will follow through on his campaign promise to cancel $10,000 of loans per borrower as part of his Emergency Action Plan amid the ongoing pandemic.

Student loan forgiveness would ease the financial burden that 42 million borrowers have long faced.

Below, we break down more on where Biden's student loan forgiveness currently stands and the implications it would have on borrowers' taxes.

Where Biden's student loan forgiveness currently stands

Biden's $1.9 trillion American Rescue Plan unveiled in late January didn't mention canceling student debt, nor did he reportedly include any student debt forgiveness in his latest proposed budget as of May 2021.

This is on the heels of his administration saying earlier this year that he supports the forgiveness.

In a Feb. 4 tweet by White House press secretary Jen Psaki, she said, "The President continues to support the cancelling [sic] of student debt to bring relief to students and families. Our team is reviewing whether there are any steps he can take through executive action and he would welcome the opportunity to sign a bill sent to him by Congress."

In early April, President Biden asked the U.S. Department of Education to see if his executive authority gives him the ability to enact massive student loan forgiveness without congressional approval.

Democratic lawmakers like Chuck Schumer and Elizabeth Warren have urged Biden to take swift action — even increasing the forgiveness to $50,000 per federal student loan borrower. Without any forgiveness included in his upcoming budget proposal, however, borrowers may not see action taken or a decision made anytime soon.

What Biden's student loan forgiveness would mean for borrowers' taxes

While the cancellation of student debt is still unknown, it's important for borrowers to know ahead of time what tax implications come with any sort of loan forgiveness.

As of March 11, 2021, Biden signed the American Rescue Plan into law, which included a provision that all student loan forgiveness is tax-free. In the past, however, loan forgiveness would have meant a big tax bill.

"Generally, when a debt is forgiven, student loans or otherwise, the amount forgiven represents taxable income in the year it is written off," Steven Rossman, CPA and shareholder at Drucker & Scaccetti, a Philadelphia-based accounting firm focusing on taxation, tells Select.

Rossman helps us break down a hypothetical example to show how federal student loan forgiveness of $10,000 would have traditionally been taxed prior to Biden's tax update.

As a federal student loan borrower, you have $10,000 of your loans canceled in 2021. This means that $10,000 would be added to your taxable income, under what's called "Cancellation of Debt (COD)" income, and you would presumably receive a Form 1099-C for 2021 as documentation.

Then, when you go to file your 2021 tax return (in April of 2022), you will have $10,000 to report as COD income. If you are, for example, in the 20% federal tax bracket, this will result in an additional tax of $2,000 ($10,000 x 20%), which will be due in April of 2022 when 2021 taxes are filed. (Tax rates will vary by individual.)

"The good news is that the borrower doesn't have to pay back $10,000, but the bad news is that they would owe $2,000 for taxes," Rossman says.

When student loan forgiveness is tax-free

Before Biden signed the American Rescue Plan into law, there were only certain exceptions that apply as to whether or not student loan forgiveness can be taxed. Finaid.org says that the forgiveness may be excluded from taxable income if it is contingent upon the borrower working for a specific period of time in a certain profession, such as with Public Service Loan Forgiveness (PSLF). Additional exceptions to taxable canceled debt can be found on the IRS website.

Rossman had speculated prior to Biden's tax update that the unprecedented circumstance of the pandemic may have meant that student loan borrowers would see additional exceptions set in place.

"As we've seen from loan forgiveness in the Paycheck Protection Program (PPP), the loans forgiven under the PPP are not taxable to business owners, if the loans are used for eligible business expenses," he says. "Perhaps this will set precedent for the taxability of student loans that are forgiven."

How to prepare now for potential student loan forgiveness

Because we don't yet know whether or not federal student loans will be forgiven, plan ahead by making sure you have money set aside no matter the outcome.

One option is to start putting money into a high-yield savings account that earns interest. The Varo Savings Account offers an above-average APY, as well as two programs that automatically transfer money from your Varo bank account to your savings account: Save Your Pay, which transfers a percentage of your paycheck into your savings, and Save Your Change, which rounds up your checking account transactions to the nearest dollar and transfers the difference to your savings.

Just putting aside $20 per week can get you to $1,000 in a year, which may come in handy if loan forgiveness falls through.

Bottom line

Student loan forgiveness in 2021 will not increase your taxable income, thanks to the latest American Rescue Plan that makes all student loan forgiveness tax-free.

Keep an eye out as Congress negotiates any additional coronavirus relief measures in the coming months, and start saving a little bit every paycheck now so that you're ready if forgiveness never happens.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.