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Situation: I have a pretty sizable student loan burden ($150,000 with 6% interest), where I can't afford the regular payments (about $2000/month) with my current salary ($60,000) at job I'm starting in a few weeks, but can under income-based repayment.

I'm worried however, about the "tax bomb" by loan forgiveness being counted as income tax at the end of the payment period if significant interest accrues on the way:

http://www.cnbc.com/2016/09/09/student-loan-forgiveness-can-come-with-a-tax-bomb.html

Here is my question: How can I prepare for this tax bomb? My limited (but attempts at research to increase) financial knowledge is if I invest in a 401K there will be a substantial penalty if I want to withdraw to pay off this potentially 50K+ tax bomb (hopefully that's all it is) at the end of the 20 years of payment.

Any suggestions?

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  • Is this United States? can you edit the tag and add country tag.
    – Dheer
    Commented Dec 15, 2016 at 5:42
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    Yes sorry my mistake it is for the US.
    – Sf_39
    Commented Dec 15, 2016 at 5:46
  • You don't happen to work for a government or a non-profit organization, do you?
    – Ben Miller
    Commented Dec 15, 2016 at 5:59
  • Unfortunately no private sector. I'm aware of public service debt relief.
    – Sf_39
    Commented Dec 15, 2016 at 15:11
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    @jamesqf Yes. Generally (depending on the particular repayment plan) the income-based plans feature loan forgiveness after 20 or 25 years. Payments adjust every year based on income, so if the income grows, the borrower might no longer qualify for the plan, or might be paying enough to clear the debt before the forgiveness happens. But sometimes the monthly payment doesn't even cover all the interest, so the loan balance actually grows. The amount forgiven under these plans is taxable, so it can be a very big tax event.
    – Ben Miller
    Commented Dec 16, 2016 at 4:43

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You have estimated that your "tax bomb" on the loan forgiveness will be $50k, 20 years from now. You prepare for that expense just as you would prepare for any other known expense that you will have in the future: You save for it. If you save $208 per month, you can stick it in a savings account, and even if you earn nothing on it, you'll have your $50k in 20 years. If you invest this money in something relatively safe, you may hit your $50k savings goal early. However, you would NOT want to put this money into any type of retirement account (such as a 401k or IRA), because you will need it before retirement.

You haven't given any specifics on the size of the loan or the size of your income, but perhaps you should reconsider some of your assumptions. Although it might seem insurmountable to you now, it may be possible to pay off the debt before 20 years is over.

If you choose to disclose more information, you might be able to get an answer that will address these things. In addition, if you aren't sure about your $50k tax estimate, providing more information about your situation would allow us to help you with that estimate. Information that might be helpful would include the size of the debt, the interest rate, the amount of your income-based monthly payment, and your income.

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  • Hi Ben thanks for your reply. I added more information to my initial post. Appreciate your time and knowledge.
    – Sf_39
    Commented Dec 15, 2016 at 6:15
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    @Sf_39 The one thing I'm not seeing yet is the amount that your monthly payment will be under the income-based repayment plan.
    – Ben Miller
    Commented Dec 15, 2016 at 6:16

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