For student loan borrowers, income-driven repayment plans could lead to a massive tax bill. 

Income-driven repayment plans are a saving grace to borrowers who struggle to make their monthly loan payments. But they come with a hidden cost most borrowers don’t consider – a very large tax bill.

After a borrower graduates from college, they are put on a standard repayment plan for federal loans. This plan requires borrowers to pay off their loan balance within 10 years, but borrowers with very high loan balances sometimes have trouble making monthly payments on the standard repayment plan.

That’s why the Department of Education started offering income-driven repayment plans in 2007. There are several different kinds of income-driven repayment plans; one plan set a borrower’s monthly payments at 10 percent of monthly discretionary income. After 20 to 25 years of payments, any remaining loan debt is forgiven.

There’s a Caveat to Income-Driven Repayment

Lower payments may seem like a good thing. but oftentimes, these payments barely cover the interest that continues to accrue monthly. This means the principal balance largely remains untouched during repayment. So although the borrower is making his or her monthly payments, the loan balance continues to grow.

Some borrowers might not realize that the government views most forgiven loan debt as taxable income (Although debt forgiven via Public Service Loan Forgiveness is not considered taxable). So a borrower could have his or her loans forgiven only to receive a very large tax bill from the IRS. For instance, a borrower who receives $40,000 in loan forgiveness may end up owing the IRS thousands of dollars.

New Bill Aims to Erase Student Loan Debt in Bankruptcy

Ironically, the borrowers who are most at risk for high tax bills are the ones with the fewest resources, The Wall Street Journal reported. Low-income borrowers don’t usually have the ability to consult with a financial planner and ensure that they are getting the best deal.

Adam Looney, a senior fellow at the Brookings Institution, told the WSJ that this is the real problem with programs like income-driven repayment plans. The government created the program to incentivize lower-income individuals to attend college. But many “of the benefits go to people who would have gone to college anyway.”

Of course, many borrowers might still be better off with loan forgiveness. But according to Ashley Harrington, a staff member at the Center for Responsible Lending, the problem is that most borrowers don’t realize this tax bill is coming. Harrington told the WSJ she is concerned about the average borrower’s ability to pay.

For people who can’t pay their taxes, the IRS has several ways to collect. They can garnish wages, Social Security checks, and tax refunds.

The first borrowers will be eligible to have their debt forgiven in 2027. As that date nears, it’s likely that Congress will come under pressure to ease this tax burden. However, eliminating the tax bill would potentially cost taxpayers tens of billions, so there is no easy answer.