There is a big question I often get when it comes to student loan forgiveness: “Won’t I get a huge tax bill at the end?” or “Yeah forgiveness sounds great but the taxes at the end aren’t worth it!”
To me this is a lot like when people complain about the taxes they’ll have to pay on winning the lottery.
First of all, I truly don’t believe that the tax problem will be there when the first people are set to be forgiven under IBR and ICR in 2034. I don’t think it will be there for a number of reasons, mainly because they didn’t intend student loan forgiveness to be taxable in the first place.
However, since the law is the way it is now it needs to be addressed so let’s get to it. There are two strategies you can use that will get around this particular issue but first we need to fully understand the problem.
The “Tax Bill” on forgiveness everyone is so scared of is not what everyone believes it is. Meaning, it is not a bill in the traditional sense but actually a 1099 in the form of ghost income. Let’s say we start the 25-year forgiveness plan with $200,000 worth of student loan debt. Then in 25 years it has ballooned up to an even 1 Million dollars in debt. So you have a full $1,000,000 forgiven, that doesn’t mean you will get a tax bill for this amount - there would be no point to forgiveness if that were the case.
What will actually happen is you will receive a 1099 in the form of ghost income showing that you made an extra $1,000,000 in income for that year. Now, hypothetically let’s imagine you made $80,000 in actual income for that year. Meaning the income you will have to report is $1,080,000. You then will end up paying taxes on that amount of income depending on your tax bracket. We’ll imagine your tax bracket will be 25%. So the taxes you will have to pay that year will be roughly $270,000.
If you're thinking “See, I started with $200,000 and now 25 years later I have to pay all in one lump $270,000!” - then take a deep breath, I have strategies for this. Even if I didn't, with the IRS you could pay $100 a month on that until you die.
Now, onto the solutions. These solutions complement each other and work best together. I recommend seeking a very good financial advisor to help you with them.
Tax Solution #1 - Investing the Savings
What if you were one of those people who had $200,000 of student loan debt and the servicers were asking you for $2,000 a month? Then you worked with us and were able to lower your payment down to $500 a month hypothetically. That is a savings of $1,500 a month or $18,000 in savings a year.
What if you took part of that savings and sat down with a good financial advisor? If you invested even half of that savings in a moderate investment vehicle with reliable returns for 20 years you could turn that into millions of dollars. This is because you would be using compounding interest in your favor. This is how financial advisors sell retirement plans. They use compounding interest with monthly payments over a long period of time to grow nest eggs.
In my opinion, this is how you really beat the student loan game. Taking the money that would have gone to a debt that can be forgiven and turning it into money that grows for your family’s future. If you give a competent financial advisor, a sum of money to grow, a goal to hit, and 20-25 years to do it in, they’ll do it because that is their job.
Now, when that “Giant Tax Bill” comes for $270,000 and you call up your financial advisor to say, “It’s forgiveness time”, that $270,000 is a drop in the bucket next to the huge mass you have created for yourself.
Tax Solution #2 - The Insolvency Exclusion
There is a tax code you are more than welcome to look up code 108 A 3, or you can simply Google the Insolvency Rule or Insolvency Exclusion. Basically, it boils down to this: you can’t be taxed on a forgiven amount of debt over and above the total value of assets that you own.
What that means is this, if you had a million dollars of student loan debt forgiven but you only had $500,000 of total assets, then the 1099 you received for the taxes on the forgiven amount would have to be lowered down to $500,000. You can’t get taxed without the ability to pay in full.
Hopefully, your mind is working because I am going to take this solution a step further.
Since we have 20-25 years to plan for the taxable event, what if we made sure that you had very little in asset value, so we could lower the 1099 amount even more? Meaning, we put everything of major value under the control of a corporate entity that you own. You create an LLC, LP, S-Corp, or C-Corp and that entity is what owns your assets. If you want to build real wealth, you should be doing this anyway for tax and liability purposes. But maybe you have never heard of this strategy. So now that your entity owns almost all your assets, it leaves almost nothing in your name.
As always, we’ll run through an example to make sure you fully understand. You have a million dollars in forgiveness and you know it is coming in the next year or hopefully sooner. You effectively move all your assets into the form of an entity and out of your name and for the purposes of this example let’s say you only leave your car untouched. The car is worth $30,000 so that $1,000,000 taxable event then gets lowered to $30,000. A much more manageable amount to deal with.
Now you see why I say these two solutions work best together. Not only are you going to take the savings each month by switching to Income-Driven Repayment and invest it, which will create hopefully a massive sum at the end of the forgiveness period, but then you are going to lower that tax liability on the forgiveness as much as possible. So you have a nest egg and a low tax bill. Effectively wiping away any concern of the taxes on forgiveness.
Brief disclaimer though, you will need a very good financial advisor and tax professional to complete these strategies. Because you will need someone to grow your savings in a way that won’t be counted against you at the end of the forgiveness period, someone to help you set up the entities to move your assets into, and a tax pro who understands how to implement the insolvency rule. You have to tell the IRS what your total assets are at the time of forgiveness for them to lower the 1099, they won’t just do it for you.
All that said I hope you will take advantage of creating wealth for yourself using these strategies instead of throwing money at a debt that is only helping the student loan system, and everybody with their hands in the cookie jar.
To learn more, call us at College Loan Freedom today, set an appointment online, or send us a message and we'll get back to you for a Free Consultation. The sooner you act the more money you can save for your future. Let us show you how.