Many people take care in preparing a tax return so that they do not pay more tax than is required. Not only can careful tax preparation minimize the amount of tax you pay, but it can also influence your monthly student loan payments. What specific tax considerations do student loan borrowers need to understand?
Income-Driven Student Loan Payments Depend Upon Adjusted Gross Income
Income-driven repayment plans (like Income-Based Repayment, Income-Contingent Repayment, and Pay As You Earn) limit a borrower’s student loan payments to an affordable level given his or her income. Monthly payments are determined based on the borrower’s adjusted gross income (AGI) and family size. You can take steps to lower your AGI and your monthly student loan payments.
AGI is figured and reported each year on your federal tax return. It is calculated before you take exemptions and the standard or itemized deduction (after you take exemptions and deductions you arrive at your “taxable income”).
AGI is made up of your total combined income from job earnings, self-employment, alimony income, and interest from bank accounts—minus specific reductions or adjustments. Adjustments are subject to change each year, but include a portion of self-employment taxes you pay, alimony payments you pay, the student loan interest deduction, and contributions to certain retirement accounts including a traditional IRA.
The higher your income, the more taxes you pay, and the more your monthly student loan payment will be
(under an income-driven repayment plan). To maximize the allowable reductions or adjustments from your total income:
Save for retirement. The best way to boost your adjustments is to save for retirement. Try to make the maximum contribution to your 401K retirement plan or traditional IRA. Your contribution reduces your income, lowers your tax bill, and at the same time lowers your monthly student loan payment.
Use health savings accounts if your employer offers them (these are known as flexible spending accounts or FSA).
Avoid using the IRS 1040A or 1040EZ forms and opt for the 1040 because only the 1040 allows you to maximize adjustments to your income.
Consider getting advice from a qualified professional tax advisor.
Married Student Loan Borrowers Face Tricky Tax Decisions
If you are married, you can choose a tax filing status of “Married Filing Separately.” A married person who wants to have his or her monthly student loan payment calculated solely on the basis of his or her own income and student loan debt must file a separate federal income tax return. Otherwise, joint AGI will be considered in calculating the monthly student loan payment.
To summarize, married student loan borrowers can choose to either:
- file taxes jointly and have a monthly payment based on joint AGI and combined student debt, or
- file taxes separately and have a monthly payment based on individual AGI and individual student debt.
Married couples living in community property states must typically pool all community income on their federal income tax return if they file their taxes jointly or to split all community income equally between them if they file their taxes separately. The Department of Education permits married borrowers in community property states to submit alternative documentation of income in lieu of the federal tax return so that borrowers in community property states are not disadvantaged.
If a married couple files a joint federal tax return, a total payment amount for the couple will be calculated taking into account both spouses’ debt and both spouses’ income. A proportion of the total payment will be assigned to each spouse based on his or her share of the couple’s total student loan debt. For example, say Demetrio owes $75,000 on his eligible federal student loans and his wife Elizabeth owes $25,000 on hers. Their joint AGI is $75,000. Under the Income-Based Repayment plan, a family of two with an AGI of $75,000 would pay a total of $654 under current rules. In this case, 75 percent of that total is due on Demetrio’s loans ($491) and 25 percent of that total is due on Elizabeth’s loans ($163).
This presents married student loan borrowers with complicated choices. Married persons filing separately have disadvantages, such as a higher tax rate and ineligibility for certain credits and deductions. Married student loan borrowers must try to weigh the value of tax benefits against student loan benefits.
Most (but not all) people will pay more combined tax on separate returns than they would on a joint return. Some of the disadvantages to a “married filing separately” tax status include:
- Your tax rate generally will be higher than it would be on a joint return.
- You cannot take the credit for child and dependent care expenses in most cases, and the amount that you can exclude from income under an employer’s dependent care assistance program is limited.
- You cannot take the earned income credit.
- You cannot take the exclusion or credit for adoption expenses in most cases.
- You cannot take the education credits, including the deduction for student loan interest.
- Deductions for contributions to a traditional IRA are reduced or eliminated if your income is more than a certain amount, and this amount is much lower for married individuals who file separately.
Recall that under Income-Based Repayment, monthly student payments are based on AGI and family size. Although AGI is driven by your federal tax return, family size is not. This means that you can count your spouse in your family size even if you choose to file separate tax returns. According to federal regulations, family size is determined by counting you, your spouse, and your children if the children receive more than half their support from you. Your family size also includes other individuals if they (1) live with you and (2) receive more than half their support from you and will continue to receive this support for the year you certify family size. Support includes money, gifts, loans, housing, food, clothes, car, medical and dental care, and payment of college costs.
Reduce Your Tax Bill by Deducting Student Loan Interest
A student loan borrower is eligible to deduct as much as $2,500 each year for interest paid on a student loan. You can deduct student loan interest on loans you took out to pay “qualified higher education expenses” (like tuition, fees, room and board, books, and supplies) for yourself, for your spouse (if you file jointly), and for your dependents. However, unless Congress acts, in 2013 the student loan interest deduction will revert to an older law in which student loan interest will be deductible only for the first five years in repayment.
The student loan interest deduction is an “above the line” adjustment to income on the tax Form 1040 or 1040A, which means you can take the student loan interest deduction even if you don’t itemize, or in addition to your itemized deductions, but you can’t take it if you file the Form 1040EZ. Your lender should send you a Form 1098-E, which shows the interest you paid.
In addition to the $2,500 cap, the amount of your student loan interest deduction is further limited according to income. Currently, if your total income is under $60,000 (or $120,000 for married people filing jointly), then you can deduct the full $2,500 in student loan interest. If your income is more than $75,000 (or $150,000 for married filing jointly), then student loan interest cannot be deducted at all. If your income is more than $60,000 but less than $75,000 ($120,000 to $150,000 for married filing jointly), then your deduction is prorated. Figure your deduction using the IRS Student Loan Interest Deduction Worksheet.
Unfortunately, married folks have to file joint tax returns to take the student loan interest deduction, and some married people will want to file separately in order to separate their incomes for figuring Income-Based Repayment.
Law students routinely borrow more than $100,000 in student loans. With interest rates between 6.8 percent and 7.9 percent, it’s not uncommon for law graduates to pay several times more than the allowable deductible interest payments.
Understand How Student Loan Forgiveness and LRAPs Affect Your Taxes
Under current rules, if a student loan borrower still has loan debt after 25 years of payments under an income-driven repayment option, the remaining principal and interest is discharged. As a general rule, income from the cancellation of indebtedness is taxable as income; however, Section 108(f) of the Internal Revenue Code allows the forgiveness of certain student loans to be excluded from taxable income if the student loans are forgiven as a result of the borrower working for a certain period “in certain professions for any of a broad class of employers.”
Law School-Based Loan Repayment Assistance Benefits Are Usually Not Taxable
Most law schools structure their Loan Repayment Assistance Program (LRAP) awards as forgivable loans, rather than as grants, to meet the requirements of Section 108(f) and permit LRAP recipients to avoid taxation of benefits. In 2008, the IRS published Revenue Ruling 2008–34, recognizing that a law school loan made under an LRAP generally satisfies the requirements of Section 108 of the Tax Code.
Public Service Loan Forgiveness Is Not Taxable as Income
The US Department of the Treasury and the IRS have issued an Information Letter confirming that Public Service Loan Forgiveness meets the requirements of Section 108(f) and is therefore not taxable income to the borrower.
Employer-Based Loan Repayment Assistance Benefits Are Nearly Always Taxable
Some employers offer financial assistance with student loan payments as a benefit to staff. If you receive such assistance, it will be considered taxable income to you.
LRAP benefits will not make you ineligible for federal loan forgiveness programs like Public Service Loan Forgiveness, but will serve to increase your AGI and therefore increase your monthly student loan payment.
Income-Driven Repayment Forgiveness Is Taxable as Income
If after 25 years of payments, a student loan borrower’s debt has been discharged, the discharge is not contingent upon the borrower’s work in a certain profession or class of employers, and so does not meet the standard set out in Section 108(f). For this reason, under current law the amount cancelled will be considered taxable as income to the borrower in the year in which it is received.
It is important to take care in preparing your taxes and be sure to take into account the student loan consequences of your decisions. Consider getting some professional advice and remember to reevaluate your strategy if circumstances in your life change.
Anyone who reads this article is advised to seek from an independent tax advisor advice based on his or her particular circumstances. To the extent this article contains a discussion of any federal tax matter, it is not intended or written to be used by anyone for the purpose of avoiding tax penalties that may be imposed by the federal government. In addition, this article may not be used to support the promotion or marketing of the transaction or matter addressed herein.
- Recognize that contributing to a retirement account lowers AGI and minimizes monthly student loan payments while building your savings.
- Married student loan borrowers need to weigh the pros and cons of filing joint or separate federal tax returns.
- 3Ls should file a federal tax return to establish adjusted gross income (for calculating monthly student loan payments under income-driven repayment options).