Your adjusted gross income (AGI) is used as a starting point to help determine your overall tax liability each year. But it also serves as one of the primary factors when calculating your federal student loan payment under an income-driven repayment (IDR) plan.
There are a variety of strategies to effectively reduce your AGI, and in turn, lower both your tax bill and your student loan payment. Here’s how.
What’s adjusted gross income?
Your AGI is basically your total gross income for the year after making adjustments for certain tax deductions.
Gross income combines all types of income received for the year, including:
- Business income,
- Capital gains,
- Retirement distributions,
- And other forms of income.
Income adjustments include specific “above-the-line” tax deductions, such as student loan interest and retirement contributions. In plain terms, your AGI is calculated as:
Total gross income – “Above-the-line” deductions = AGI
However, not all tax deductions are considered “above-the-line”. For example, deductions for medical expenses and mortgage interest are considered “below-the-line” tax deductions and can only be claimed if you itemize your tax return (which most people don’t because the standard deduction is so high now).
An itemized deduction ends up reducing your taxable income, which lowers your overall tax liability. But they won’t affect your AGI calculation.
This is an important distinction to understand because your AGI has a direct relationship with your federal student loan payment: the lower your AGI, the lower your monthly payment.
How AGI affects student loan payments
The Department of Education offers a number of repayment plans to federal student loan borrowers, including four income-driven repayment plans. Each of these IDR plans uses a different percentage of your discretionary income (ranging from 10% to 20%) and has a different goalpost for accessing student loan forgiveness benefits (20 to 25 years).
However, all of the IDR plans work the same in terms of using your AGI and family size to determine your monthly payment.
The federal government uses your discretionary income to calculate your monthly payment. Discretionary income takes your previous year’s AGI and subtracts 150% of the federal poverty line for your family size.
For example, let’s say your AGI is $100,000 and you have a family of four. The 2021 poverty line for a four-person household is $26,500. Therefore, your discretionary income would be $60,250 for the year.
From there, your discretionary income is multiplied by the appropriate percentage based on the IDR plan you’re enrolled in. That number is then divided by 12 to determine your final monthly payment amount.
Using the same example, let’s say you’re enrolled in the Revised Pay As You Earn (REPAYE) plan that uses 10% of your discretionary income. Your monthly payment would be about $502.
But what happens if you could strategically lower your AGI by $15,000? Your new payment would drop to roughly $377 per month.
Use our Income-Based Repayment Calculator to quickly plug in your own numbers and see how reducing your AGI could affect your student loan payment.
Strategically reduce your AGI for lower student loan payments
Reducing your AGI is the most effective way to lower your federal student loan payment (the alternative is to increase your family size). Fortunately, there are a handful of strategies that can make a major dent in your AGI, while also benefiting you for the long-term.
Here are several ways to reduce your AGI by using “above-the-line” tax deductions to your advantage.
Increase your pre-tax contributions to your retirement plan
Contributions made to a pre-tax retirement plan can lower your AGI and help set you up for retirement later down the road. This includes contributions made to a 401(k), 403(b), 457, government pension fund or a traditional Individual Retirement Account (IRA).
Note: It doesn’t include Roth IRA contributions since that type of retirement plan involves after-tax dollars.
If you have access to a retirement plan through work, you can significantly lower your AGI by maxing out your pre-tax contributions each year.
For example, the 2021 maximum limit for a 401(k) or a 403(b) is $19,500.
But let’s say you’re a government employee with access to both a 403(b) and a 457. You can max out both accounts at $19,500 per year. This means you can shave off a total of $39,000 from your AGI by focusing on your retirement savings.
There’s also the option to max out a traditional IRA at $6,000 per year regardless of whether your employer offers a retirement plan. However, your deduction might be limited if you or your spouse are covered by a retirement plan at work. In this case, there are modified AGI limits to consider.
Keep in mind that your spouse can contribute to their own IRA or employer-sponsored retirement plan.
Contribute to a Health Saving Account (HSA)
If you have a high deductible health plan (HDHP), you can make tax-deductible contributions to an HSA for future medical expenses. HSA accounts offer tax-deferred growth and tax-free withdrawals (when used on qualified medical expenses). But they can also save you money by reducing your AGI, and thereby, lowering your student loan payment.
For 2021, you can contribute up to $3,600 if you have self-only HDHP coverage or up to $7,200 for family HDHP coverage.
Claim the student loan interest deduction
Private and federal student loan borrowers can deduct up to $2,500 of paid interest on their qualified student loans. However, the student loan interest deduction has modified adjusted gross income (MAGI) limits.
If your MAGI is $85,000 or more ($170,000 or more for married filing a joint return), then you won’t qualify for this tax deduction. However, if your MAGI is less than these parameters, you might be eligible to claim the full deduction or a partial deduction based on phaseout guidelines.
Use our Student Loan Interest Deduction Calculator to see how much you could save on your taxes, including how phaseout eligibility requirements will impact you.
Claim the tuition and fees deduction
If you, your spouse or a dependent was enrolled in college the previous year, you might be able to claim the tuition and fees deduction for any paid qualified education expenses.
This deduction has MAGI limitations and a phaseout, as well. But if you have a MAGI less than $80,000 (or less than $160,000 if married filing a joint return), then you might be eligible to claim a deduction up to $4,000.
Note: The future of this deduction is unsure. It was previously eliminated by the Tax Cuts and Jobs Act in 2017, but was retroactively renewed and extended through the 2020 tax year.
Expenses that aren’t included in AGI
As mentioned earlier, some tax deductions lower your overall tax liability, but they won’t impact your AGI or your student loan payment. However, it’s still beneficial to understand potential deductions for:
- Charitable contributions
- Mortgage interest
- State and local income, sales and property taxes
- Medical costs
Keep in mind these “below-the-line” deductions require you to itemize your tax return. Most people claim the standard deduction ($12,550 for single and $25,100 for married filing jointly). But if all of your eligible combined expenses exceed the standard deduction, you can save money by tracking and itemizing these deductions.
Plan ahead for your taxes and student loans
If you have a large amount of federal student loan debt, then your taxes and student loans should go hand-in-hand.
This is especially the case if you’re pursuing Public Service Loan Forgiveness or overall IDR forgiveness. Save as much money on payments as possible, and receive the largest forgiveness benefit in the end.
If you need tax prep help that factors in your unique student loan situation, we recommend using Student Loan Tax Experts. Be sure to mention Student Loan Planner as your referral source to receive a free 30-minute consult and discount.
However, if you need a long-term strategy for paying off your student loans, our team of student debt experts are here for you. We’ll create a customized repayment plan to help you maximize your finances by looking at all angles of your financial, personal and career goals.