Higher education is a major expense for many taxpayers. About 66 percent of college graduates from the class of 2017 took out student loans at an average of nearly $30,000, according to U.S. News data.
Whether you’re in school or the job force, student loans can help or hurt at tax time. Private and federal student loan borrowers stand to gain from tax breaks, but student loan debt can also cause a tax burden with forgiven or settled loans. Here’s what to know.
Tax Credits and Deductions for Students
Tax credits and deductions that apply to educational expenses could reduce your tax bill or increase your refund.
Tax credits. If you paid for education costs (with student loans or not), the IRS allows you to claim the American Opportunity Tax Credit and the Lifetime Learning Credit. Both are tax credits, which reduce the amount of your income subject to tax.
You can claim up to $2,500 each year for up to four years with the American Opportunity Tax Credit. If this credit reduces your income tax to less than zero, you could get a refund. Under the Lifetime Learning Credit, you can claim up to $2,000 per return. It can reduce your tax bill but won’t generate a refund.
Student loan interest deduction. If you pay interest on either private or federal student loans, the student loan interest deduction will let you reduce your taxable income by up to $2,500 annually.
“Congress understands that the cost of college is an incredibly high expense,” says Kristin Ingram, CPA and owner of Accounting In Focus, an accounting education website. “This is something they have provided to help people with that expense.”
When you reduce the amount of your income subject to taxes, you won’t have to pay taxes on that income. And it could push you to a lower tax bracket, which could translate to even more tax savings, Ingram says.
To claim the deduction, you must have used the loan to pay for qualified education expenses for you, your spouse or dependent. Your loan servicer should send you a Form 1098-E that shows how much interest you paid during the tax year. If you used a credit card to pay for qualified expenses and paid interest on the debt, the IRS says you can claim that interest, too.
There are two downsides to the student loan interest deduction, Ingram says. You can only claim the $2,500 deduction once per return, whether you’re single or filing jointly. That means if you’re paying student loans for yourself and a spouse, you’ll only get to claim it once.
What’s more, the deduction starts decreasing as you earn more income. Once your modified adjusted gross income is $80,000 or more filing single, or $165,000 or more filing jointly, you’re not eligible for the credit at all. “People who tend to rack up a lot of loans are the people who are probably going to hit those thresholds,” Ingram says. “So they still have those payments, but they don’t get the benefit of that deduction.”
If your parents helped pay for your school costs, then you’ll need to consider who will claim the tax credits along with the student loan interest deduction. It can be either you or your parents, but not both. The answer comes down to:
- Dependent status. To qualify for these tax breaks, you can’t be listed as a dependent on someone else’s tax return.
- Filing status. Filing separately means you can’t claim any of these three education tax breaks.
- Income. Tax breaks usually have income limits, so you’ll have to compare your income against your parents’. If one of you meets the income requirements, you can claim the tax break as long as you fit any other qualifications.
Your Tax-Filing Status Can Impact Your Student Loan Payment
Federal student loan borrowers have a lot of flexibility in repayment, including four income-driven repayment plans that limit monthly payments to a percentage of the borrower’s income reported to the IRS. After the borrower makes on-time payments for 20 to 25 years, the government will forgive any remaining balance.
If you have a federal student loan and file a joint return with a spouse, the Department of Education bases your payment on the two incomes combined. If your joint income increases enough after you get married, your payment may increase substantially or the income may even disqualify you from certain repayment programs. The Department of Education does help you a little here by prorating your loan payment if your spouse is also paying off a federal student loan. But if you and your spouse decide to file separately, the monthly payment will be based on just your income.
There’s one exception: The Revised Pay As You Earn Plan doesn’t take into account whether you file jointly or separately. It will base your payment on the combined income of you and your spouse.
Mark Gianno, CPA and president of financial services company Gianno & Freda, has a client who is married but filing separately specifically to get a lower federal student loan payment. “In the process, he’s giving up an awful lot to get the forgiveness,” Gianno says. For example, separate filers will generally pay a higher tax rate, can’t claim certain credits and deductions (such as the student loan interest deduction), and may get a reduced child tax credit. And once the loan is forgiven, Gianno says, there’s a tax hit: The forgiven amount will generally be considered taxable income.
If two people have “radically different income” and the person with the lower income has a large student loan, then it might be worth it, Ingram says.
Settled or Forgiven Student Loans Can Lead to Bigger Tax Bills
There are two main ways to pay less than originally agreed on your student loans: debt settlement and loan forgiveness.
If you default on a student loan, meaning you’ve missed several payments, you may be able to negotiate debt settlement. That means the lender will accept a smaller lump sum as payment in full. But while it’s possible, it’s not guaranteed, and your credit rating will take a major hit as you miss payments.
Loan forgiveness is a program for federal student loan borrowers. After you’ve made payments for 20 to 25 years, the government will forgive any remaining balance on the loan.
But here’s one of the major downsides to settled and forgiven loans: The IRS will count any discharged debt as taxable income. So if you’re in the 22 percent tax bracket and your $40,000 loan was forgiven, you’ll owe $8,800 in additional taxes.
You may qualify for an exemption, such as insolvency, that allows you to exclude the discharged debt from your gross income. You’re considered insolvent if the fair market value of your total assets is less than your total debt. “If you are still fairly new out of school and living in an apartment and trying to scratch out a living,” Gianno says, “you can probably show insolvency, if you don’t really own anything.”
Here’s some good news: If you have federal student loans and can qualify for the federal Public Service Loan Forgiveness program, the government will forgive your remaining loan balance after you make 120 qualifying payments. Under this program, you won’t owe taxes on the balance. This program was created “to increase the talent pool for potential employees in the public service,” Gianno says.
Student Loans Aren’t Considered Taxable Income – But What Else Is?
The IRS defines income as just about any money you receive: wages, salaries, commissions, fees, tips and more. Taxable income is any income left over after you’ve subtracted allowable deductions and adjustments.
When you tap into methods of paying for school, you’ll need to consider whether the IRS will see the funds as taxable income. Here are two examples of what generally is and isn’t taxable:
Student loans, scholarships and grants: generally not taxed. Student loans, whether private or federal, generally won’t be considered taxable income because they’ll be repaid at some point. Of course, if the debt is later discharged, you may have to pay income taxes on the balance. Academic scholarships and grants generally aren’t considered taxable income, but a few rules apply. You must be a degree-seeking student at an eligible institution, use the funds only for qualified expenses and meet a few other requirements.
Employer-provided perks: generally taxed. If your employer either foots your tuition bill for higher education or offers a benefit that helps you pay for student loans with an educational assistance program, these funds may be taxable. You won’t have to pay taxes on the first $5,250 of an educational assistance program, but you’ll generally have to pay taxes on benefits that exceed that amount. On the other hand, 100 percent of student loan repayment assistance is viewed as taxable income.
Consider Planning Before Taking Out Loans
If you’re still in school and haven’t taken out many student loans, Ingram suggests taking a look at what your budget might look like after graduation.
“People spend so much time focusing on student loans after they’ve already got them,” she says. “They try to figure out how to repay them and what tax deductions to take.” She says the smarter move is to spend more time thinking about these details before taking out a loan.