By Dr. James M. Dahle, WCI Founder
Managing your student loans properly and minimizing your tax bill are both critical parts of a solid financial plan. However, the two are not completely separate—they affect each other. How you file your taxes can affect your student loan bill, and your student loan management strategy can affect your tax bill. In this post, we'll discuss how they interact.
Is Student Loan Interest Deductible?
Many types of loan interest are deductible, such as mortgage interest, investment interest, and even student loan interest.
Interest from both federal student loans and private student loans can be deductible. However, there are limitations.
The first limitation is a $2,500 annual limit. So even if you pay $12,000 (6% on a $200,000 loan) in a year, you only get to deduct $2,500 of it.
The second limitation is an income limitation. For 2021, if you have a Modified Adjusted Gross Income (MAGI) greater than $70,000 ($140,000 Married Filing Jointly (MFJ)) your deduction will be phased out. Once your MAGI hits $85,000 ($170,000 MFJ), there is no deduction at all.
How Much Can This Student Loan Interest Deduction Save You?
A deduction, unlike a credit, is simply income on which you do not pay taxes. To calculate how much tax a deduction saves, you must multiply the deduction by your marginal tax rate, informally known as your tax bracket. If you are in the 12% federal tax bracket and a 5% state tax bracket, your $2,500 deduction reduces your tax bill by $2,500 * 17% = $425.
As you can tell, this is not a particularly valuable deduction, so it certainly doesn't make sense to keep your student loans around longer than necessary “for the tax deduction.” It doesn't make sense to pay $2,500 (and certainly not $10,000-$15,000) in student loan interest every year just to save a few hundred dollars in taxes.
Are Student Loan Payments Tax Deductions?
The payment itself is not a tax deduction. The only entity that can deduct the entire student loan payment is an employer who has set up a student loan payment program. A taxpayer cannot deduct an entire payment, only the interest paid and even then only up to $2,500 a year.
How to Claim the Student Loan Interest Deduction
Student loan interest paid is reported to the taxpayer and the IRS by the lender on IRS Form 1098-E. It's a very simple form:
In turn, the taxpayer reports that interest on IRS Form 1040, Schedule 1. In 2020, it went on line 20 of that form as an “above the line” deduction, meaning you don't have to itemize in order to claim the deduction.
The instructions for this line (line 95) say:
- You must have paid the interest during the tax year
- You must have a MAGI < $85,000 ($170,000 MFJ)
- You are not a dependent of anyone else
- You cannot include any amount paid from a 529
- You can deduct interest paid for your student loans, your spouse's student loans, or your dependent's student loans
- You cannot deduct the interest if the loan was used for anything but paying for school or if the lender is related to the borrower
The number at the bottom of Schedule 1 plugs into Line 10a of the main Form 1040.
Student Loan Forgiveness and Taxes
If you are going for student loan forgiveness, you need to be aware of how that forgiveness will affect your taxes. If you receive forgiveness through the Public Service Loan Forgiveness (PSLF) program, there is no associated tax bill.
There are actually a few more ways to get tax-free forgiveness than PSLF. These include the teacher loan forgiveness program, some law school student loan repayment assistance programs, and the National Health Service Corps Loan Repayment Program.
However, ANY OTHER FORGIVENESS is fully taxable in the year it is received at your ordinary income tax rates. This includes student loan forgiveness from:
- IDR programs (IBR, PAYE, REPAYE)
- Death and disability
- Closed schools
- Fraudulent schools
- Unpaid refunds
Are Student Loans Taxable? Do They Count as Income?
Student loan payments are not deductible, and they're not taxable income either. Student loan forgiveness can be (although not PSLF as mentioned above), but the loans themselves are not. This is not unusual. No loans are taxable income whether they are:
- Student loans
- Mortgage loans
- Car loans
- Credit card debt
- Margin loans
- Loans against your 401(k)
- Loans against your life insurance cash value
Loans are always “after-tax money,” and you always pay them back with “after-tax money.”
Student loan interest, like the interest on many of the loan types above, can be deductible, but the loans themselves are not taxable income.
Filing Taxes with Student Loans
Since student loans are not taxable income, you don't have to file a tax return if your only income is a student loan. However, you may wish to do so anyway, especially in your last year of school. That tax return is used to show your income when you enroll in the IDR programs. By filing that tax return, you can benefit from $0 IDR payments that first year out of school. Zero dollar payments can improve your cash flow, can maximize your REPAYE subsidy, and can even increase how much forgiveness you receive through the PSLF or IDR forgiveness programs.
Student Loan Tax Forms: How Do I Report Student Loans on Taxes?
Good news! Since student loans are not taxable income, you do not have to report them on your taxes at all. There are no student loan tax forms except those shown above relating to the student loan interest deduction (1098-E) and those related to student loan cancellation (1099-C).
What About Tax Filing Status?
There are certain tax-filing strategies that people can use to best manage their student loans. Some people are hesitant to get married, lest it affects the size of their IDR payments or the amount of student loan forgiveness they receive. Even once someone is married, they may choose to file taxes Married Filing Single (MFS) rather than Married Filing Jointly (MFJ) in certain situations to minimize their IDR payments and to maximize their forgiveness. This often has the result of increasing their tax bill, so one must run the numbers to determine whether they come out ahead in the end. If you need assistance running those numbers, we recommend StudentLoanAdvice.com.
What About Student Loans and Retirement Accounts?
Likewise, there are strategies that involve retirement accounts and student loans. If you are trying to minimize your IDR payments to improve cash flow, maximize the REPAYE subsidy, and/or maximize forgiveness, you want to keep your income as low as possible. You can do so by contributing to tax-deferred retirement accounts like traditional IRAs, 401(k)s, 403(b)s, 457(b)s, solo 401(k)s, SEP-IRAs, and SIMPLE IRAs instead of investing in a Roth or a taxable account. You may also wish to put off withdrawals from any personal or inherited IRA.
How Much of Your Paycheck Can Student Loans Take?
If you have defaulted (360+ days delinquent) on your federal student loans, the federal government can garnish part of your paycheck. However, it's limited to 15% of your “disposable pay,” although you can never be left with less than 30 times the Federal minimum wage of $7.25 per hour ($217.50 per week). That means if you are making less than $13,306 a year, there will be no garnishment. Disposable pay is defined as the borrower’s pay after subtracting health insurance premiums and any amounts that are required by law to be deducted (e.g., Social Security taxes and income tax withholding). Note this amount is very different from (and probably much larger than) the “discretionary income” (income minus 150% of poverty level) that is used to determine IDR payment size.
Private student loan lenders can also go after your pay. If they can get a court order to do so, they can seize up to 25% of your income.
How Much of Your Tax Return Can Student Loans Take?
The government can also take money from your disability or retirement Social Security payments or even your tax return to pay your delinquent student loans. This is called an “offset” rather than a “garnishment.” With disability and Social Security payments, the 15% of disposable pay rule still applies. However, your entire federal and/or state tax return can be taken. Might be a good reason to adjust those withholdings on your W-4 or reduce your quarterly estimated payments so your return is smaller.
The government can seize lottery winnings, can sue you to put a lien on your property, or can do bank levies as well. It is probably best to just enroll in an IDR program if you're having trouble making your payments.
What do you think? What interactions have you seen between your taxes and your student loans? Comment below!