Written By Travis Hornsby, CFA®, CFP®
I can think of about 600,000 things that are better than talking about taxes, but it’s something we can’t ignore. In my experience, most people pay way more in taxes than they’re supposed to be paying.
I’d rather keep that money in my pocket. Wouldn’t you?
Let’s dive in so we can understand what you’re paying in taxes and why. Then we’ll jump into long-term tax planning strategies and what you can do right now to lower your tax bill as a student loan borrower.
But first, keep in mind that this isn’t considered tax advice. Make sure you talk with your tax professional if you have questions about any of these strategies.
What you need to know about adjusted gross income
Adjusted gross income (AGI) is the magic number that so many things in our lives are based on. If you’ve ever tried to qualify for a government program or wondered if you’re able to buy a house or not, your AGI is your taxable income.
Income tax brackets in the US
The progressive tax structure in the United States charges a lower percentage of income taxes if you’re poor than if you were wealthy.
Tax brackets If you’re single
If you’re single, you get about a $12,000 standard deduction. Hypothetically, you could earn $12,000 and pay no taxes.
Above that, even if you make just $1 over the standard deduction (or your itemized deductions, which very few people do), you move to the 10% tax bracket so long as you stay under $22,000 of income.
The next step is $22,000 to $52,000, and that’s taxed at 12%.
The higher your income, the higher a percentage of taxes you pay. For example, once you make around $200,000 to $500,000, you’re paying about 35% in income taxes.
Tax brackets if you’re married
Things get interesting if you’re married. Basically, the government charges the same amount of taxes if you make less than about $350,000, whether you’re single or married. That is, unless one spouse makes a lot more money than the other.
In that case, there are a lot of tax benefits if you make between $0 and $350,000 because your combined income is what matters.
So, if you’re making $350,000 as a single person, your tax rate is 35%. But if you’re making a $350,000 combined income, such as if you’re making $330,000 and your spouse is making around $20,000, your tax rate is about 24%. That’s an 11% tax savings.
What about investment income?
If all of your income is from capital gains and dividends, you could make up to $104,000 before you’d have to pay anything in income taxes.
According to the current tax code, you pay a 0% qualified dividend tax rate if your income is between $0 and $80,000 before deductions.
Anything above that is taxed at about 15%. Unless you’re a high-income earner, then you’ll pay about 20% and get hit with the Affordable Care Act (ACA) tax that’s an additional 4% on capital gains and dividend income.
For instance, take this hypothetical example: Let’s say Max and Cathy each earn $150,000 a year. If they’re single, the ACA tax doesn’t apply to their dividends and capital gains. The limit for married couples isn’t double that of singles as you’d expect. The threshold is just $250,000. Max and Cathy make $300,000 combined, so they’d have to pay the ACA tax.
On top of the income tax, you also pay a Medicare tax of about 1.5% and Social Security tax of 7.5% (unless you’re self-employed, then you pay about 12%).
The good news is that the government puts a limit on earnings subject to the Social Security tax. In 2020, you won’t pay that tax on earnings over $137,700.
If you think about it, someone making $200,000 to $500,000 is paying 35% income tax, 1.5% Medicare tax, and 7.5% Social Security tax. That’s a 44% tax rate — almost half of your money.
How student loan borrowers can reduce their taxable income
Taxes are mostly based on wages. The way it’s set up, if you’re making over $100,000 as a single person, or $200,000 if you’re married, you’re getting beat up by the tax system.
If you’re pursuing any kind of student loan forgiveness, your goal should be to reduce your taxable income — your AGI — as much as possible. When you do that, you achieve two things:
- You reduce the amount of income taxes you owe.
- You lower your student loan payment.
Maxing out your retirement contributions is one of the best ways to lower your taxable income.
To start, put 5% in retirement and $100 a month into a brokerage account. Once you have that first step established, focus on maxing out your retirement accounts before adding money into your non-retirement accounts.
Maximizing tax savings and retirement as a business owner
If you’re a business owner, you have a big opportunity to lower your taxes. For instance, a dentist who owns a dental practice can set up the business as an S corp for tax purposes. The dentist could set an annual salary of $120,000 to avoid falling into a higher tax bracket while also avoiding extra taxes for Medicare and Social Security.
Business owners can also use depreciation to write off a portion of the building that they own every year, along deducting the interest on practice loans and equipment.
Retirement plans are also better for business owners. You could add $100,000 of pre-tax dollars to your retirement savings, for example, instead of being limited to $19,500 as employees are.
How to save money on taxes right now
Student loan borrowers have several options to consider when taking steps to lower their tax bills. What steps you take depends on your specific circumstances, though. Use the following list of questions and choices to help you make the right moves on your taxes in 2020 and in the future.
1. Filing joint vs. separate tax returns
If you’re single, the choice is obvious: You’ll file your taxes as a single person. But if you’re legally married, you can choose between filing jointly and filing separately.
If you’re married and make a very different income than your spouse, your income tax will be less if you file jointly.
The benefits of filing separately can depend on what student loan repayment plan you’re on. If you’re on an income-based plan or pursuing student loan forgiveness, your monthly payment is a percentage of your income. With the right plan, you can lower your monthly payment if you file separately.
2. What if you’re on PAYE or REPAYE or IBR?
If you file jointly, the payments will be the same on the PAYE and the REPAYE plans, which is 10% of your income, while IBR takes 15% of your income.
If you’re married but file separately, your PAYE and IBR payments are based only on your income. To know if it’s worth it to do so, compare what your payments would be if you filed separately or jointly.
3. Amending old tax returns
When filing tax returns separately, you can miss out on some of the deductions that married couples can cash in on when they file jointly. You can amend tax returns from separate to joint and get all that money back.
Just don't do it immediately after you certify your income for your student loans. Wait for your tax return to be at least two years old so that it’s no longer involved in the recertification process.
You could get anywhere from a few thousand dollars to a mid-four-figure amount depending on your tax situation.
4. Community property states
In a community property state, your student loan situation will be very complicated if you’re married.
There are nine community property states in the U.S.:
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
You won’t notice any difference if you’re married and you file jointly in a community property state. But if you’re married and file separately, your income is equally distributed across both spouses.
For instance, let's say that one spouse makes $200,000, and one spouse makes $0. In a state like New York without community property law, you will have $200,000 and then $0, so you'll probably file taxes jointly and do PAYE or REPAYE. Otherwise, the penalty for filing separately would be so large that it wouldn't give you any benefit.
In a community property state, however, if you file taxes separately, the income is split between two spouses. Each spouse has $100,000 of earned income. When you file separately, your tax penalty is basically nothing. Plus, if you're doing the PAYE plan, you get to pay 10% of $100,000 instead of 10% of $200,000. This is called the breadwinner loophole.
Where to go for more tax help
It’s helpful to have a CPA if you have complicated tax situations. If you’re an employee and get a W-2, you don’t need a CPA to do your taxes. Instead, you could use TurboTax or other software to do it yourself.
If you want assistance with your taxes, we have a partnership with a tax firm that can help. If you’ve been procrastinating, reach out to them as soon as possible if you’re not sure what to do with your taxes this year.
Just keep in mind that typical tax professionals won’t understand why you would do a specific tax filing status because of your student loans. They can’t tell you if filing a joint or separate tax return is better.
To know which tax filing status is best for your student loan repayment plan, we can give you clarity. Our team of student loan consultants can tell you which tax strategy would benefit you the most so that you’re not paying more than you need to on your student loans.
