3 ways student loans affect your taxes
Brianna McGurran, NerdWallet April 10, 2016
Originally posted on USA Today
(Photo: Getty Images/iStockphoto)
Anxiety at tax time is common, but Millennials feel it more than others.
Millennials are the age group most worried about filing their taxes, according to a recent NerdWallet survey conducted by Harris Poll.
Factoring in student loan debt can be especially confusing. “You’d be surprised how many people out there don’t even think that’s relevant for their tax return,” says Eric Schaefer, a financial adviser at Evermay Wealth Management in Arlington, Va.
Here are three ways student loan debt affects your taxes, from deductions to tax bills you might owe in the future.
1. You can deduct student loan interest from your income.
If you paid interest on student loans last year, you can lower your taxable income by up to $2,500.
Student loan borrowers can deduct the interest paid last year through the student loan interest deduction. The IRS looks at modified adjusted gross income to see who qualifies and for how much. You qualify for the full deduction if your modified gross is less than $65,000 (filing as a single or head of household) or $130,000 (if married and filing jointly). You get a reduced amount if it’s up to $80,000 (single) or $160,000 (filing jointly).
The deduction can lower your taxable income by a maximum of $2,500, which gets you $625 back on your taxes if you’re in the 25% tax bracket. The borrower who took out the loan, whether it’s the student or the parent, will get the deduction — but neither will qualify if the student is listed as a dependent on a parent’s tax return.
Your student loan servicer, the company that collects your monthly bill, should have sent you a Form 1098-E interest statement by early February if you paid $600 or more in interest last year. Ask your servicer for the document if you paid less than $600 in interest; you’ll still be able to deduct that amount, but you might not receive the form in the mail or by email without a request.
2. Filing jointly with a spouse could increase your student loan payment.
More and more grads are opting for income-driven repayment plans to pay off their federal student loans. These plans limit your monthly payment to a percentage of your discretionary income. Plus, they forgive your loan balance after you’ve made payments for 20 or 25 years.
The way you file your taxes can significantly affect how much you owe on income-driven plans, though. If you file jointly with your spouse, your monthly payment will be based on the two incomes combined. That could increase your bill or even disqualify you from certain repayment plans if your income jumps high enough.
Instead, consider filing your taxes separately. When you do, the income-based and Pay As You Earn repayment plans will calculate your monthly payment using the student loan borrower’s income alone.
“It might make financial sense to do that vs. having a monthly loan payment that’s twice as high,” Schaefer says.
There are a few financial considerations and potential downsides to choosing married filing separately, though. For example: You won’t be able to take certain tax deductions and credits (including the student loan interest deduction), and your ability to contribute retirement savings to a Roth IRA will be limited. When you file taxes separately, you can’t contribute to a Roth IRA if your modified adjusted gross income is more than $10,000 a year — compared with the $184,000 threshold for married taxpayers.
“That is a huge disadvantage for doing married filing separately,” says Ara Oghoorian, an Encino, Calif., financial planner at ACap Asset Management who works primarily with health care employees. If you can’t otherwise afford your loan payment, however, the benefits of filing separately could outweigh the drawbacks.
To make it more complicated, Revised Pay As You Earn (known as REPAYE), the newest income-driven student loan repayment plan, combines married borrowers’ incomes when it calculates your payment even if you file taxes separately. That might influence whether you choose this option to repay your loans.
3. You could be in for a big tax bill if your loans are forgiven later on.
You’ll get your federal student loans forgiven after a certain number of years if you take advantage of the government’s Public Service Loan Forgiveness program, or if you choose an income-driven repayment plan. But these two options affect your taxes very differently.
You’ll qualify for Public Service Loan Forgiveness after you’ve made 120 on-time loan payments while working full time at a non-profit or government agency. There’s an extra benefit, too: The forgiven amount won’t be taxed.
As it stands now, however, a borrower on an income-driven plan will pay income tax on the forgiven loan balance the year his or her repayment period ends. That means grads or parents with large loan balances could be in for a big tax liability.
Use the Repayment Estimator tool on Federal Student Aid’s website to see how much you should expect to have forgiven in the future.
“You might want to set aside money knowing that that’s a risk,” Schaefer says. But there may be reason to be optimistic about a change in policy.
“I wouldn’t be surprised if the IRS came up with a program to pay those tax bills in installments,” he says.
Brianna McGurran is a staff writer at NerdWallet. Email: firstname.lastname@example.org. Twitter: @briannamcscribe.
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