As we approach tax season, trying to find out how much student loan interest is deductible and which filing method is best for my student loan repayment options is confusing. Due to COVID and the suspension of loan payments, many will have less of a deduction depending on what they did during the suspension.
Another common issue borrowers face is finding the best way to file their taxes while minimizing their student loan repayment. According to the Department of Education, more than 56% of student debt dollars are being repaid using an Income-Driven Repayment. This adds new complexity to the tax filing decision and is not often reviewed by the tax advisor.
Since 2016, more student loan dollars are being repaid using Income-Driven Repayment (IDR) methods such as Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE). With this change, the traditional loan repayment strategies also changed. By using the IDR method, the taxpayer needs to do some additional tax planning. The IDR methods use a borrower’s Adjusted Gross Income (AGI) to determine the amount they will be paying which is directly related to their income and how they file their taxes.
IDR and Married Couples
Married couples could have up to 126 different student loan repayment and tax filing combinations if they both have federal loans. If you were married last year or if one of the spouses needs to start repaying their student loan, a proper tax analysis is highly recommended. We suggest a full review of your loan repayment options with the various tax filing choices.
As you can see in the chart below, a simple adjustment in a couple’s tax filing status, debt structure, and income management can result in a significant change in the student loan monthly payment. The Tax advisor’s focus is to lower your tax burden and may not understand the impact of how the Income Drive Repayment methods are affected.
Student Loan Interest Deduction Phases Out
There is a phase-out of this deduction based on how a person or couple files their taxes and their income. The student loan interest deduction was originally on the cutting block under the initial tax reform act that started in 2018. The deduction was maintained which will be a big help for many citizens.
A borrower’s tax filing status will determine when that phase-out begins. This deduction uses a person’s Modified Adjust Gross Income (MAGI) to determine if you qualify. It also adds back a few additional tax exclusions that most borrowers will not have as listed below:
- Foreign Earned Income Exclusion
- Foreign Housing Exclusion
- Foreign Housing Deduction
- Income Exclusion for residents of American Samoa and Puerto Rico
The table below is the income limits to qualify for the student loan interest deduction based on a person’s or couple’s MAGI for the 2020 taxes.
If a couple or one of the spouses is using an IDR repayment method, you will need to take an additional step that most people do not do. As you can see from the first chart, monthly payments can change significantly. You need to compare your AGI number and the impact it may have on your student loan repayment. The tax advisor’s job is to lower your taxes. That goal could be contradictory to lowering your monthly student loan payment in many cases. Properly managing the borrower’s AGI could result in hundreds of dollars a month in a lower payment.
Let’s review this by tax filing options and student loan repayment impact. The tax filing and repayment options are only available if a borrower has federal student loans.
Single, Head of House Hold and Qualified Widow
In each of these cases, the tax filing status will have no impact on student loan repayment. The Qualified Widow is the exception and only if the surviving spouse has outstanding student debt. In that case, they may want to contact their loan servicer or weigh their other tax filing options to manage their AGI better.
Married Filing Joint
A couple filing married and joint will still qualify for the student loan interest deduction. The problem they may face is with their IDR repayment. If both have federal loans, the income for the IDR repayment will be based on the percent of total federal loans by each borrower times the joint AGI.
If only one borrower is using an IDR method, this will make the payment much higher. Evaluating the filing married and separate should be reviewed to see if the tax increase will offset the monthly repayment amount.
Filing Married but Separate
By filing married but separate, the couple will generally be paying a higher tax than filing married and joint for a variety of reasons. Regarding the student loan interest deduction, this will disqualify either of the filers from the deduction.
There could be a significant advantage to filing your taxes this way when it comes to loan repayment. If one of the spouses is using an IDR method, then only their AGI number will be used to calculate their loan repayment method. Here is where the borrower needs to be more aware of their situations and options.
In most cases, the tax advisor will not ask you additional questions or see the impact of filing your taxes this way. The PayForED Student Loan Repayer, a student loan solution provides the borrower with this additional analysis so the proper interpretation and decision can be made.
For people married in the prior year and who will be filing their taxes for the first time as a couple, a full review should be done by a tax professional. This is especially true if either of the spouses has federal loan repayment under the IDR methods.
A big mistake many couples make is not correctly analyzing their options. There is a significant drop off in people qualifying for Public Service Loan Forgiveness after years 3 and 4. It is my opinion this occurs for a few reasons. One is their income goes up faster, and they do not qualify any longer. Another reason is the correlation between the age of the couple getting married and filing their taxes jointly. Filing their taxes jointly raises their incomes and repayment becomes higher.
Student Loan Assistance Benefit Impact on Interest Deduction
More companies are adding a new employee benefit called a Student Loan Assistance program. This benefit is to reduce the financial stress related to student loan repayment. Before March 2020, this was considered income for the employee and a salary expense for the employer, which are both taxable.
Starting in April 2020, it was converted to a tax-free benefit under the CARES Act and extended until 2025 under the Consolidated Appropriations Act. It follows the rules of tuition reimbursement under IRS section 127. This could make the calculation a little more difficult since the amount paid is a reimbursement now. This may limit some people’s ability to take the deduction since you will not be able to use the same interest expense for multiple tax advantages.
Tax Advice Summary
As you can see, the student loan interest deduction is not as easy as it appears. The tax advisor’s goal is to lower a person’s or family’s taxes. Many tax advisors do not understand student loan repayment, especially the Income-Driven Repayment methods. Borrowers need to take the extra steps for themselves to both lower their taxes and their loan repayments at the same time.
The PayForED Student Loan Repayer calculates both the loan repayment options and the impact of the taxes under each scenario. With this information, people can make informed decisions and improve their financial future. If you need professional advice, PayForED does have a list of College Funding and Student Loan advisors.
Disclaimer: PayForED is not a tax consulting firm. Any of the above information needs to be reviewed by a tax advisor since other tax items could impact your results.