It’s almost tax time, and if you have student loans, they can have an impact on your tax return this year and beyond. It’s important to take time to understand your student loans and tax laws surrounding your specific situation. You may not be taking full advantage of tax benefits that would save you money this year. What do you need to know about taxes and student loans?
Credits and deductions: filing taxes with student loans
Student loans themselves don’t have an impact on your taxable income. Student loans, no matter what kind, don’t count as taxable income. They also can’t be subtracted from income.
When it comes to student loans and taxes, borrowers can take advantage of some tax perks in the form of credits and deductions. Both are helpful and can save you money, but they’re different. Tax deductions reduce your taxable income. Tax credits reduce your tax bill dollar for dollar. What credits and deductions are available for people with student loans?
Student loan interest deduction
Some eligible borrowers can deduct the interest paid on student loans. Certain conditions apply, though. According to the IRS:
“If your modified adjusted gross income (MAGI) is less than $80,000 ($165,000 if filing a joint return), you may be allowed a special deduction for paying interest on a student loan (also known as an education loan) used for higher education.”
When filing taxes with student loans, your interest deduction can reduce your taxable income up to $2,500. Note that this deduction also applies to refinanced private loans. Your student loan interest could be tax deductible, even after refinancing.
Tuition and Fees Deduction
Unfortunately, one student loan deduction is no longer available for borrowers. The Tuition and Fees Deduction that allowed for up to a $4,000 deduction for qualifying education expenses expired.
Tax credits available for students
There are two credits available when filing taxes with student loans right now:
- The Lifetime Learning credit
- The American Opportunity credit
The main difference between these two credits is that a student can only claim the American Opportunity credit for four years. The Lifetime Learning credit doesn’t have a limit to the number of years you can claim it. In any given year, you can only claim one of these credits on your taxes.
Lifetime Learning Credit
This credit offers up to a $2,000 credit per tax return. It’s great for those attending grad school or pursuing continuing education opportunities. The Lifetime Learning Credit is available for all years of postsecondary education and for schooling to improve job skills. In addition, you don’t need to be pursuing a degree or specific certification to be eligible for the credit.
American Opportunity Credit
This credit offers up to a $2,500 credit per eligible student. You must be pursuing a degree or qualifying certificate to be eligible. You also need to be enrolled at least half time for at least one academic period during the tax year.
To qualify, you must’ve been within your first four years of your undergrad program before 2018. Eligibility depends on your academic status, which is determined by your school. Qualifying expenses include tuition, fees, and required course materials.
There’s a limit on the modified adjusted gross income (MAGI), which is $180,000 if married filing jointly and $90,000 for single, head of household, or qualifying widow(er). Of the credit, 40 percent may be refundable; the rest is nonrefundable.
Tax offset on default loans
Although you should always try to be in good standing with student loan repayment, this doesn’t always happen. Some people miss payments or can’t make payments long term. If they don’t do anything about it, they ultimate default on their loans.
What some borrowers don’t realize is if you default on your student loans, the government can garnish your tax refund. This is called tax offset. Your tax return is taken and used to pay off your defaulted loan.
If there’s anything left after the loan has been paid, you’ll receive the balance. If you file jointly, your spouse’s refund can be garnished as well. Should this happen, your spouse can request their portion be returned to them if they aren’t responsible for the debt.
Taxes for loan cancellation and loan discharge programs
Another way student loans and taxes collide is if you had a loan canceled or discharged. In this case, the amount that was forgiven is considered taxable income. You’ll have to report the amount as income to the IRS, which could raise your tax bracket. Some of the most common student loan cancellation and loan discharge programs are:
- Closed School Discharge
- Cancellation for False Certification of the loan
- Cancellation for unpaid refund of the loan
- Total and Permanent Disability Discharge
- Death Discharge
A change to this program for the 2018 tax year and beyond is that death and disability discharges after December 31, 2017 are now tax-free. Previously, almost all loans canceled or paid on your behalf through loan cancellation and loan discharge programs were considered taxable income.
IBR and PAYE strategies for married couples
If you and your spouse have direct federal student loans, you may be taking advantage of federal repayment plans like the Income-Based Repayment (IBR) Plan or Pay As You Earn (PAYE) Repayment Plan.
Both IBR and PAYE have monthly loan payments based on Adjusted Gross Income (AGI). One strategy couples can use to lower monthly student loan payments is to file taxes as “married, filing separately.” If you file jointly, your monthly payment will be based on your joint AGI. But if you file separately, your monthly payment will only be based on your own AGI.
This doesn’t apply to Revised Pay As You Earn (REPAYE), which solely uses your married joint AGI.
You’ll need to crunch the numbers to see if this strategy makes sense for you. A potential snag is that typically filing separately may actually cause couples to pay more taxes than they would filing jointly. Couples need to weigh the pros and cons of savings on monthly student loan payments versus paying higher taxes. It’s not always black and white when dealing with student loans and taxes.
Student loans and taxes: loan forgiveness
How forgiven student loans and taxes are handled depends on the specific loan forgiveness program you’re pursuing. It’s important to pay attention to all of the guidelines set forth by the IRS concerning your specific loan forgiveness program.
Federal loan forgiveness programs
Federal loan forgiveness programs refer mainly to Public Service Loan Forgiveness (PSLF) and Teacher Loan Forgiveness. Both of these loan forgiveness programs are tax-free. So, if you’re pursuing either of these programs, consider this another bonus to having your loan balance forgiven.
Student loan repayment assistance programs can also fall under this category and can be tax-free but not always. These programs vary on taxability of forgiven debt. For instance, Harvard Law School’s Low Income Protection Plan (LIPP) program states that its assistance shouldn’t be considered taxable income “if the participant works for a government agency or a tax-exempt section 501(c)(3) organization and receives the repayment assistance in the form of a loan that is later forgiven.”
Another example is the National Health Service Corps Loan Repayment Program, which is considered not taxable as well. Every program varies when it comes to student loans and taxes. So be sure to take time to familiarize yourself with the guidelines concerning your specific loan forgiveness program.
Student loans and taxes: the loan forgiveness “tax bomb”
There’s another loan forgiveness option that involves being on one of the four federal Income-Driven Repayment (IDR) programs. After making payments for 20 to 25 years (depending on the program), any remaining student loan debt is forgiven. The four IDR programs are:
- Income-Contingent Repayment (ICR)
IDR loan forgiveness can cut an unbelievable amount of money off your loan debt. However, it’s not all positive for borrowers. There are tax consequences that apply to all loans forgiven under the four IDR programs.
At the end of your 20 to 25 year repayment period, your loan balance will be forgiven, but having to claim the forgiven amount as taxable income is a “tax bomb” waiting to blow up. You could owe between 10 to 37 percent of the amount forgiven, depending on your taxable income after loan forgiveness. This is a significant increase that you’ll need to be ready for when that time comes.
Paying attention to the rules and guidelines when filing your taxes with student loans is extremely important. You could get hit with higher taxes than you bargained for, or you could miss out on some key credits and deductions that could save you money.