Tax planning with student loans in mind is just as important as a repayment plan itself. With the right planning, you can achieve a higher level of financial efficiency, putting more money back in your pocket.
Tax filing status and marital status impact your payment when you’re on an income-driven repayment (IDR) plan. Tax planning is more important than ever this year since the coronavirus pandemic has significantly affected income and unemployment in every state, industry and major demographic group in the U.S.
Many borrowers were able to take advantage of student loan payment relief via the CARES Act student loan payment pause and 0% interest since March 13, 2020. President Biden’s transition team announced it will extend the payment and interest freeze on federal student loans again, which was set to expire on January 31, 2021. It didn’t say how long it would extend these protections, however, so we are (yet again) in limbo.
By the time this article is published, we might know the new expiration date. What I’m even more interested in is guidance on what will happen with recertification due dates.
Annual recertification of income
When a borrower is on an IDR plan, they must update their monthly payment based on income every 12 months by on their plan anniversary date. This is called annual recertification of income, or simply recertification.
Your recertification due date — or anniversary — is found through your aid data download on StudentAid.gov OR via your servicer’s website or past recertification correspondence.
Student Aid’s online recertification application links back to your most recently filed tax return to verify income via the IRS Data Retrieval Tool. This can either increase or decrease your payment depending on what income was used to derive your payment the year before.
Calculating your discretionary income
It’s not a secret how they calculate your payment. It’s just an annoying math equation to find your discretionary income which is what your payment is based on.
Calculating your discretionary income starts with your adjusted gross income (AGI) which is your gross income minus any above the line deductions such as pre-tax retirement or HSA contributions or the student loan interest deduction.
Adjusted Gross Income can be found on your IRS form 1040: line 11 for the 2020 tax year; line 8a from 2019. So why does AGI matter?
Well if 2020’s AGI is higher than 2019’s, your payment will go UP when payments resume. If AGI was lower in 2020 than 2019, your payment could go DOWN.
Waiting for IDR recertification guidance
No one has been required to recertify income between 3/13/2020 and 1/31/2021, regardless of whether their recertification date would have happened during that time. As part of the payment suspension, recertification dates had been pushed out from their original recertification dates.
Originally, Student Aid’s guidance was that recertifications for those who’s due date fell between March 13, 2020 to December 31, 2020 would be postponed by 12 months. So if your original due date was April 1, 2020, your new recertification date would be April 1, 2021.
Now Student Aid’s guidance reads:
“You will not have to recertify your income before Jan. 31, 2021, regardless of whether your recertification date would have happened prior to Jan. 31, 2021. As part of the payment suspension, your recertification date has been pushed out from your original recertification date.
You will be notified of your new recertification date before it is time to recertify. If you have moved, changed phone numbers, or have a new email address, you should contact your loan servicer to provide updated contact information.”
So it’s not clear if there’s another recertification due-date push and for how long.
Taxes and strategic IDR recertification
Remember, when you’re recertifying your income, applying for a new repayment plan, or recalculating your IDR payment, the application is linked back to your most recently filed IRS tax return. As of this writing, that’s the 2019 tax return for most folks since many haven’t filed their 2020 tax year yet.
If you’re pursuing Public Service Loan Forgiveness (PSLF) or taxable forgiveness, your goal is to keep your payments as low as possible to maximize loan forgiveness. If timing allows, strategically using a lower tax return to calculate your payment can help you achieve that goal of keeping your payments as low as possible, for as long as possible.
If you’re in need of tax help, check out our friends at Student Loan Tax Experts. Do a free 15 min chat, and if you end up hiring them you could get a discount on their services for being an SLP reader.
Recertification example 1
A borrower is pursuing PSLF. Assume they had an April 1, 2020 recertification due date that was postponed to April 1, 2021 due to the CARES Act.
Scenario 1: 2019’s AGI was lower than 2020. They can still recertify using 2019’s income if they haven’t filed a 2020 return yet. This keeps their payment lower, for longer, when payments resume.
Scenario 2: 2020’s AGI was lower than 2019. Recertification notices are received 60 to 90 days in advance. Prior to their April 1, 2021 due date, they can file 2020’s taxes and THEN complete their annual recertification linking the application back to their lower 2020 tax return to keep their payment as low as possible.
Recertification example 2
A borrower’s recertification due date is October 1, 2020. The CARES Act initially postponed this due date by 12 months to October 1, 2021. Assuming payments resume in February 2021, their pre-pandemic payment would resume until they’d have to recertify, which would then recalculate their payment off of 2020’s income, if filed.
Without guidance on annual recertification due dates, though, strategically planning this out could be challenging. And once guidance is received, it might be too little, too late to optimize anything.
What should you do?
If 2020’s AGI was lower for you than 2019, file your taxes, normally. When you’re required to recertify, the payment will be based off of that lower 2020 tax return.
If 2019’s AGI was lower and your recertification date is normally before April 15, but you haven’t received any instruction to recertify, hold off on filing 2020 taxes until you absolutely have to so you can still try to link back to 2019 ASAP. You can always file a tax filing extension, too, if needed.
Marriage & tax filing status: how it impacts your IDR payment
Things get a little tricky when a borrower on an IDR plan is married because, unlike any other debt out there, federal student debt payment calculations are impacted by your tax filing status and your spouse’s federal loans, if applicable.
How so, you ask?
Scenario 1: If you’re married, and your spouse doesn’t have student loan debt, then the following payment changes could happen based on your tax filing strategy:
- If you file taxes jointly: Your payment is based on your joint, adjusted gross income.
- If you file taxes separately: Your payment is based on your own income unless you’re on REPAYE, which counts joint income regardless of how you file taxes with your spouse.
- If you file taxes separately AND reside in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin: Your payment is based on a 50/50 split of your household income if filing via community property rules on IRS form 8958. See more notes on this below.
Scenario 2: If you’re married, and your spouse also has student loan debt, then the following payment changes could happen based on your tax filing strategy:
- If you file taxes jointly: Your payment is based on joint, adjusted gross income, but is divided proportionally between your respective balances. For example, let’s say you owe $25,000 and your spouse owes $75,000. You’ll have 25% of the household monthly payment calculation and your spouse will have 75%.
- If you file taxes separately: Your payment is based on your own respective incomes unless you are on REPAYE, which counts joint income regardless of how you file. Each spouse’s payment is calculated in proportion to their debt amount. Filing separately will also count the poverty line deduction for your household size twice, because each of you report it separately.
- If you file taxes separately and reside in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin: Your payment is based on a 50/50 split of your household income if filed via community property rules on IRS form 8958. It also counts the poverty line deduction for your household size twice.
- Things can get even more interesting if you file separately and you’re a good candidate for the double-debt loophole.
What to watch for when filing separately
Filing separately can be a great strategy to help reduce your monthly payment and achieve cash-flow efficiency. A few indicators to look for when deciding if you should file separately are:
- You’re on track for PSLF or taxable loan forgiveness, and your goal is to minimize your payment as much as possible to maximize your forgiveness.
- You and your spouse keep your finances separate and/or you alone are responsible for your student loan debt.
- You (and your spouse) can’t afford a higher monthly payment if spousal income is factored in.
- You want optimal payment efficiency to maximize cash flow.
Filing taxes separately is not usual
There are very few circumstances when filing taxes separately from your spouse makes financial sense. It’s not unusual for your certified public accountant (CPA) to raise an eyebrow if you ask about filing separately for student loan purposes.
What needs to be explained is that filing taxes together while only you have student loans on an IDR plan can raise your monthly payment significantly and throw off your student loan repayment strategy.
There’s a “crossover point” to look for. If the difference between filing jointly versus separately costs you less than the cost savings of your monthly payment filing separately over the course of the year, then you have the green light on filing separately.
Tax planning for residents of community property states
Living in a community property state has a unique advantage when filing taxes separately from your spouse. Using the IRS tax Form 8958, the total household income is split in half, reducing the tax implication of filing separately, significantly.
Traditionally, married couples file taxes jointly. There aren’t a lot of circumstances that make filing separately more advantageous from a tax perspective over filing taxes jointly even in community property states. Your CPA — even if familiar with community property state laws — might not know to divide income correctly if they’re not familiar with IRS Form 8958.
I see mistakes with this issue more often than not. If you get your tax return back and your community property 50/50 split wasn’t done correctly, you need to fix it to avoid unnecessary tax costs. If you’ve been filing incorrectly, you can amend your tax returns as far back as three years to recoup any tax overpayment. Just make sure you don’t amend the most recent tax return you might need for recertification soon.
Downsides to filing taxes separately for student loan purposes
Keep in mind there can still be downsides to filing taxes separately that you should evaluate to ensure that your payment’s cost savings aren’t eroded by the potential consequences of filing separately. These are the things you could be giving up (if applicable):
- Education credits or student loan interest deduction of $2,500 — this might not be applicable to you, however, if you have a modified AGI between $140,000 and $170,000 as a married couple
- More advantageous tax brackets, unless you’re in a community property state
- Child care tax credit
- Earned income tax credit
- Exclusion or credit for adoption expenses
- Ability to contribute to a Roth IRA, though you can still utilize the back-door Roth conversion method
- Ability to deduct rental property losses
- Ability to take the standard deduction if your spouse itemizes, or vice versa
Feel overwhelmed? Not sure what the best strategy is for you and your spouse? Schedule a consultation with me for your customized student loan repayment plan.