A “student loan forgiveness tax bomb” happens when your loan balance is forgiven and you must pay taxes on that amount. This primarily affects borrowers on income-driven repayment plans.

In this situation, you may face a potentially large tax bill that’s due in full immediately. The best way to prepare for this is to estimate your projected student loan forgiveness and set aside money early for that future tax bomb.

Who faces a student loan tax bomb?

Borrowers who use income-driven repayment plans are most likely to experience a student loan forgiveness tax bomb. These plans last 20 or 25 years, and if you don’t pay off your loan during that term, your remaining balance is forgiven — but taxed as income.

If you receive forgiveness under a different federal student loan program, it will likely be tax-exempt. You won’t face a tax bomb in the following situations:

  • You work for a qualifying employer. Amounts forgiven through Public Service Loan Forgiveness and Teacher Loan Forgiveness, as well as the National Health Service Corps Loan Repayment Program and similar repayment programs, aren’t taxable.
  • You become totally and permanently disabled (or die). This applies to you or the student benefitting from the loan, in the case of parent PLUS loans. In instances of a death discharge, your estate won’t be taxed.
  • You qualify for a different federal student loan discharge. Loans can be discharged tax-free in instances in which your school defrauded you or closed while you were enrolled, for example.
  • Your Perkins loans are canceled. If you taught or performed other employment or volunteer service that qualified for Perkins loan cancelation, you won’t be taxed on this amount.

Many states offer their own student loan forgiveness programs. For example, the Maine Dental Education Loan program offers eligible dentists up to $20,000 annually as a forgivable loan. Such programs are usually tax-exempt, but check with the program’s operator or a tax professional to understand your liability.

If you have a forgiven student loan, you should receive a cancellation of debt form, known as Form 1099-C, for your taxes.

How much will you pay?

The size of a student loan tax bomb depends on the amount forgiven as well as your finances overall. In some instances, the forgiven student loan could push you into a higher tax bracket — further increasing your tax burden.

For example, say you’re married, file taxes jointly and have two dependents. If your taxable income was $100,000 and you claimed the standard deduction, you would fall in the 12% tax bracket and owe $4,684 in taxes.

But let’s say you also had $50,000 in student loans forgiven. That additional income would move your federal return into the 22% tax bracket, increasing your tax bill to $15,349 — a $10,665 difference.

That additional income may also affect your state taxes. Some states don’t have income tax, and Minnesota, for example, does not tax amounts forgiven under income-driven repayment plans. Check with a tax professional about your situation.

How to prepare for a forgiveness tax bomb

If you don’t think you’ll fully repay your loan over a 20- or 25-year term, use that time to prepare for the fallout of a potential tax bomb.

  • Estimate your bill. Use the Repayment Estimator at studentaid.gov to project your loan forgiveness amount. Tax brackets can change over time, but looking at your earning potential with data from the Bureau of Labor Statistics can help you at least estimate how much you’ll eventually owe.
  • Choose the right plan. When deciding between income-driven plans, many factors matter, like your degree and marital status. Revised Pay As You Earn, or REPAYE, can make the most sense if eventual forgiveness is likely. This plan offers the best interest subsidy, which can help keep your balance from ballooning.
  • Prioritize saving. Instead of paying extra toward your loan, invest money with your forgiveness tax bomb in mind. For example, set aside $50 a month for your eventual bill. That small amount may not make a dent in your loans, but after 25 years with just 2% compound interest, you’ll have saved more than $19,600 — hopefully enough for your tax bill. A savings goal calculator can help you determine how much to put aside.

What if you can’t afford your tax bill?

If you’re on an income-driven plan, you may not have money to set aside for a potential loan forgiveness tax bomb — let alone things you actually want to save for, like buying a home or retiring.

Payment plans are available if you can’t afford your tax bill. IRS payment plans charge fees and interest, and rates can change every three months. As of the first quarter of 2020, the interest rate was 5%.

In some cases, if the IRS regards you as insolvent — or having liabilities that exceed your assets — you may be able to exclude some or all of the forgiven amount from your income. Talk to a tax professional after your loan is forgiven to understand whether this is an option for you.

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Ryan Lane is a writer at NerdWallet. Email: rlane@nerdwallet.com. This article originally appeared on NerdWallet.

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