How do student loans impact your taxes?
These days, it is almost impossible to attend college without a student loan. But did you know that these loans have quite a few implications on your tax bill? The way that student loans impact your taxes can be rather complicated, and it may differ from one case to another. In some cases, your best bet is to seek one of the best tax debt help solutions from professional tax advisors. However, most of the time, simply knowing about the implications is enough. This article will explain exactly how student loans and taxes mix so you can make informed decisions.
Is my student loan considered income?
Before we get into more detail about student loans and taxes, it is important to understand that your student loans are not considered taxable income, as you need to pay them back at some point. If you simply take a loan and pay it back in due time, you do not have to worry about their interaction with the tax system. Only when your student loan gets forgiven, you pay interest on the loan, or the loan itself gets canceled due to one reason or another, is when taxes get into the proverbial picture.
How student loans impact taxes
Three factors influence how taxes and student loans interact. They are:
- Student loan interest deduction
- Tax Refund
- Forgiven/Cancelled student loan debts
If you are looking to reduce your tax bill, there are also numerous other ways in which you can do so. You may look into a few of the tax breaks for higher education, for example, or you may use any of the popular tax deductions. The U.S. tax system is incredibly complicated, however, so you may need some professional assistance along the way.
That being said, let’s take a look at the situations in which your student loans may impact your taxes.
Student loans may qualify you for the student loan interest deduction
The most common way in which student loans impact your taxes is through student loan interest. Any interest that you pay on your student loans is tax-deductible. There is a limit of money you can deduct, of course. For the 2022 tax year (due in 2023), the limit was $2,500. As one of the most popular tax deductions, this deduction is an “above-the-line” one, meaning that you do not need to itemize your tax return in order to claim it.
It is also important that this deduction is not a tax credit, but it will reduce your taxable income instead. Furthermore, according to the IRS topic No. 456, student loan interest deduction, this deduction will be gradually reduced according to your MAGI (modified adjusted gross income) limit.
You can claim a student loan interest deduction in the following cases:
- Your MAGI is lower than the specified amount, which is set annually
- You paid interest on a qualified student loan during the tax year
- Your filing status is not “married filing separately”
- You have a legal obligation to pay interest on a qualified student loan
- You are not claimed as a dependent on someone else’s tax return
If your interest is at least $600, your loan servicer will provide you with Form 1098-E. You can also request this form from your servicer/lender. This document will have all the information on your paid interest and possible deductions.
Specified MAGI amount
The only thing that is somewhat confusing about the above list is the “specified MAGI amount”. What that actually means is that once your MAGI is above $70,000 ($140,000 for married joint filers), the deduction starts to phase out. The best way to calculate the exact write-off is to either hire a tax consultant or use tax filing software. Alternatively, you may also look at the IRS Publication 970 and use the worksheet provided there. It all depends on how much of your time and energy you are willing to invest.
Finally, once your MAGI exceeds $85,000 ($170,000 for married joint filers), you will no longer be able to benefit from this deduction.
Defaulted student loans may compromise your tax refund
If you happen to default on your student loan, the federal government may change your federal tax refund. This is done through the Treasury Offset Program (TOP). TOP collects all debts that businesses and individuals owe to the federal government, including defaulted student loans.
You will be given prior notice, of course, as the Department of Education is legally obliged to provide you with 60 days’ notice before they send your defaulted student loan to TOP. This allows you to get your tax refund back or to work out a payment agreement.
There are two options when it comes to getting your tax refund back:
- Collection errors
- Injured spouse
No system is perfect, and it is entirely possible that the government makes a clerical error. If you have paid your student loan debt instead of defaulting on it, you can contact either your loan servicer or the Department of Education to fix the issue. In fact, you might want to make it a habit to get in touch with tax authorities every time you see something suspicious. This is the best way to protect yourself from common IRS tax scams that involve student loans. When it comes to taxes, it is always best to be 100% certain.
Your forgiven student loan debts might not be taxable
Another way in which student loans impact your taxes is through debt forgiveness. Due to the American Rescue Plan, signed in March 2021, any taxpayers who have forgiven student loans, whether private or federal, can exclude debt forgiveness from their taxable income. Furthermore, you may be able to take advantage of president Biden’s student loan forgiveness program, where you can apply for up to $20,000 of student loan debt. However, this program is being legally challenged, and it is not yet clear if it will go through. Nevertheless, tens of millions have applied for it.
Aside from this particular program, there are several other notable programs that allow for debt forgiveness, such as the Total and Permanent Disability Discharge program, Borrower Defense to Repayment program, as well as the Public Student Loan Forgiveness program. Not all loans are eligible for forgiveness, of course. If you want to cut your tax bills on account of loan forgiveness, the best thing to do is to talk to your CPA or a professional tax advisor.
There are two options for student loan forgiveness and taxes: Public Service Loan Forgiveness (PSLF) and Income-driven repayment forgiveness.
Public Service Loan Forgiveness
If you happen to qualify for PSLF, you will not need to worry about paying any taxes on the forgiven amount. To qualify, you will need to:
- Be working for a qualified employer
- Make 120 qualifying payments
It is also possible to get debt forgiveness for Perkins Loans, FFEL, or even Direct Loans, in the same manner. However, there are a few additional steps involved. For example, you could have applied for a limited PSLF waiver until October 31, 2022. Similar to how there are so many different types of taxes in the USA, there are always time-sensitive offers floating around. You may want to broach the subject with your tax professional.
Income-Driven Repayment Forgiveness
The second student loan forgiveness option is income-driven repayment forgiveness. This option makes you eligible for loan forgiveness after either 20 or 25 years have passed, depending on the plan. After this time, the rest of the debt will simply be canceled.
Now, the problem with this cancellation is that it usually comes with a tax bill. Meaning that you can suddenly be looking at tens of thousands of dollars in due taxes. However, due to the recent changes brought by the COVID-19 relief plan, you may be able to “get off the hook”.
COVID-19 Relief in regards to how student loans impact your taxes
The advent of COVID-19 has temporarily changed the interaction between student loans and taxes. Any forgiveness due to income-driven repayment is not considered to be taxable income. This will hold true through the tax year 2025. Furthermore, all interest payments on student loans have been halted. This effectively means that you will most likely not be able to take advantage of any student loan interest deductions.
There may be other ways in which student loans impact your taxes, as well. As mentioned previously, the tax code is incredibly complex and complicated. It might so happen that your case is special and that there is something else that you can do. It may be in your best interest to contact a tax professional, preferably someone specialising in student loans.
You can find the best tax professionals right here at the Consumer Opinion Guide. Our tax knowledge database is also there to provide you with all the answers to any of your tax-related questions!