Could the relief of finally wiping out student debt turn into a costly surprise? For millions of borrowers on income-driven repayment plans, that’s the looming question as a key tax exemption is set to expire in 2026.
The 2021 American Rescue Plan made student-loan forgiveness tax-free at the federal level. That protection has saved borrowers from what advocates call a “tax bomb,” the sudden requirement to pay income tax on the amount of debt erased. Unless lawmakers act, however, the exemption will expire in January 2026, and forgiven balances could be treated as taxable income.
An analysis by Protect Borrowers estimated that the average borrower who completes an income-driven repayment plan in 2026 could be hit with between $5,800 and $10,000 in federal taxes. “By punishing IDR beneficiaries with massive tax bills, the federal government undermines the very purpose of the IDR program,” Sen. Elizabeth Warren and her colleagues wrote in a letter to Treasury Secretary Scott Bessent, urging the IRS to use its authority to prevent this outcome.
The lawmakers cited the general welfare exclusion, a legal principle by which some types of government payments can be excluded from taxable income if they advance the well-being of the recipient. Because income-driven repayment plans peg monthly payments to earnings and target borrowers with demonstrated need, they argue that loan forgiveness under these plans should qualify.
Borrowers who hit their qualifying payment threshold in 2025 are off the hook. The Department of Education has made clear the “effective date” of relief is the date a borrower completes the required payments – not when the discharge is actually processed. That means someone who finishes payments in 2025 but sees their balance zeroed out in early 2026 won’t face federal taxes thanks to the 2025 effective date.
The risk, nevertheless, is real for those whose forgiveness date falls in 2026. Canceled debt under current tax law is generally treated as income, unless excluded by statute. As Georgetown law professor John R. Brooks explained, you’re better off because you don’t have the liability, but you haven’t generated the cash to pay the tax. This mismatch can create acute financial stress, particularly for working-class borrowers who have already spent decades making payments.
There are steps borrowers can take to prepare now. Financial planners recommend reviewing repayment timelines to see if forgiveness will come before the exemption does. If not, start setting aside money that could be used for taxes. Even small, consistent savings such as setting aside $25 a month for 25 years at modest interest could cover a sizable tax bill.
Borrowers should also consider whether they might qualify for what is called the insolvency exclusion, which allows debt relief to be excluded from taxable income if liabilities exceed assets at the time of forgiveness. A tax professional consulted well in advance of the discharge date can clarify eligibility and help borrowers avoid last-minute stress.
It’s equally important to check state tax rules. While most states follow federal law, some, including Arkansas, Indiana, Mississippi, North Carolina, and Wisconsin, may tax forgiven student loans even if they’re exempt federally. Knowing the rules where you live can prevent unwelcome surprises. Those still in repayment should stay proactive: Confirm the details of their loan servicer; keep contact information current; and make sure payments are properly recorded. Missing documentation or incorrect payment counts could delay forgiveness and push it into the taxable window.
Reviewing the repayment plans annually may also help in aligning forgiveness dates with the most favorable tax conditions. Advocates continue to push for a permanent fix. Past bipartisan efforts have aimed to end taxation on debt forgiven under income-driven repayment, and states like California have acted to protect residents from the penalty. Through congressional action or IRS interpretation, borrowers and lawmakers alike are hoping the relief they’ve worked toward for decades won’t be undermined by an unexpected bill from the tax collector.
