While people don’t bother to do their homework on student loan tax, it is vital to understand the tax implications of student debt as well as loan forgiveness, whether you have already taken a loan or intend to do so in the future.
Student loans come second only to mortgages as far as consumer debt is concerned, and why not? In the last 12 years, tuition at public colleges has increased by almost 40%. The net costs of higher education, including books, boarding, transportation, and other ancillary expenses, have also ballooned by nearly 25% per year.
So, it would not be wrong to say that for anybody who is keen on a college degree, student loans have become an inevitability. This explains why nearly 70% of all American students funded their higher education with loans in 2019.
The back-breaking burden of student debt!
Most of these borrowers take out loans assuming that they will, in time, repay the debt. Unfortunately, for many students the repayment quickly gets unmanageable. The problem is that while the average borrowings per student stands at $35,000, that’s how much people spend on a single year of college. This means you will have to borrow significantly more than this average.
To compound the issue, the monthly student loan repayments have increased by a massive 60% over the last few decades. When you combine the increased cost of education with the rising interest payments, it becomes easy to understand why and how nearly 1 million people end up defaulting on their student debt each year.
In fact, so widespread is the problem that as many as 25% of all Americans have defaulted on their student loan payments. This has left the country grappling with outstanding student debt of nearly $1.5 trillion.
The tax shark looms large in the waters of student loans and student debt forgiveness!
To add to this conundrum, there are tax implications to both paying interests on your student loans as well as accepting debt relief.
If you don’t know how student loans and student debt relief can impact your taxes, you could end up losing thousands in tax refunds or even owing thousands in taxes. And you certainly don’t want to get into trouble with Uncle Sam! So, continue reading to know whether your student loan can help or hurt at tax time and if and how debt forgiveness can cause trouble for you this tax season.
Impact of student loans on taxes
Educational expenses and student debt can reduce your tax burden in two ways. They can either get you a refund or lower your taxable income, thus reducing your tax bill. The tax breaks come in two forms:
1. Tax deductions: Because they lower your taxable income, deductions indirectly lower the amount of income tax you owe. If you have paid interest on student loans in the last financial year or are a current student, you can claim federal education deductions.
2. Tax credits: These offer a commensurate (dollar-to-dollar) value reduction in the actual amount of taxes you owe, without impacting your taxable income. The eligibility for these credits differs as does the amount of these tax breaks.
While there is a very good possibility that you will be eligible for some form of tax break on your student loan, certain criteria have to be met to qualify for such deductions and credits. Moreover, there is an upper limit on the tax benefits that you can claim.
Are student loan payments tax deductible completely?
No, they are not. The thing to understand here is that you can only claim tax breaks on the interest that you pay and not on the principal. For example, if you have borrowed $35,000 at 6%, your monthly payment would be $358. Of this, $260 would go towards the repayment of the loan while $98 would be the interest on the loan.
So, through the lifecycle of the loan, you will end up paying $13,165 in interest and of course the entire principal of $35,000. Now, only the interest qualifies for the tax deduction and this too is capped at a maximum of $2500 annually.
This means that although you will pay $9,996 in interest every year (as per calculation above), you can only claim a deduction of $2,500.
Another thing to notice is that this is a tax deduction and not a tax credit, which means that you cannot simply reduce this amount from the taxes owed. The $2,500 will be deducted from your total taxable income and then taxes will be applied to this new amount.
For example, if your annual taxable income is $60,000, after the deduction, it will go down to $57,500. In case you are wondering about the dollar value of the tax break, it works out to approximately $600.
So, what happens if your interest payment for the year is below $2,500? You only get to claim a deduction on the actual amount of interest paid. For instance, if you have paid $1,000 in total annual interest on your student loan, you can only deduct this amount from your taxable income and not the upper deduction limit of $2,500.
Are you eligible for a student loan interest tax deduction?
You can claim tax deductions for student loan interest payments if you meet the following criteria:
- 1. The loan has to be a qualified student loan.
- 2. You should be legally obligated to repay the loan, which means you should be the signatory on the loan.
- 3. You paid interest in the tax year
- 4. Your filing status should NOT be married filing separately
- 5. You should not be dependent on the tax returns of another person.
- 6. Your income is less than $65,000 if filing as a single filer and $135,000 if married filing jointly (more on MAGI coming up next).
How do income limitations impact taxes on student loan interest?
The $2500 deduction is also limited by your modified adjusted gross income (MAGI). If your taxable income exceeds a certain amount to reach the phase-out range, you will only qualify for prorated deductions.
If your income exceeds the higher limit of this phase-out range, you will not qualify for the $2,500 deduction. This is what the phase-out range is depending on your filing status:
- Single, widow(er), head of household: $70,000 to $85,000
- Married filing jointly: $140,000 to $170,000
You can get more information on the prorate deduction from IRS Website (page 89).
If you opt for this plan, you should be comfortable parting with 20% of your discretionary income. This is the highest percentage of the four PSLF income-based plans. However, it is your best bet if you have a parent plus loan. This is because after consolidating into a Direct Consolidation plan, you only require 10 qualifying years on ICR. Since this plan needs you to remit 20% of your unrestricted income, it would be of good help if you have a Parent Plus loan exceeding $50,000.
A few more things to consider when claiming student loan tax deduction
- 1. If your parents have been shouldering the costs of your education, either you or your parents can claim the tax credits for such expenses, but not both.
- 2. If your employer/company pays off your student loans, these payments would be considered as a part of your income and they will be subject to payroll taxes
- 3. Credit card interest can be deductible if used to fund qualified education expenses. However, this can only work for you if every charge on the card went towards qualified expenses. Even a single non-qualified charge would make all interest ineligible for the deduction.
- 4. If your parents or a family member pays off your student debt, you won’t have to pay tax on this gift. However, the person repaying the loan will have to pay taxes on the total amount gifted (paid) and will have to file a gift tax return.
Can you get student loan tax credits?
You are also eligible for 2 tax credits as long as you meet certain criteria, even if you are claiming student loan interest deduction. These include:
- 1. The American Opportunity Tax Credit (AOTC): You can claim up to $2500 per year for up to 4 years. If the credit reduces your tax payments to zero, you can claim a refund of 40% of the remaining credit. For example, if you are eligible for AOTC and your tax bill for the year is $4000, you could knock off $2500 from it, which would leave you with just $1500 in outstanding taxes.
If your tax liability for the year is $1000, the credit would reduce it to zero. So, you won’t pay any taxes. Plus, you can claim a refund of up to 40% on the balance credit ($2500- $1000) of $1500, which would be $600. Information on AOTC eligibility is available at IRS Website
- 2. Lifetime Learning Credit (LLC): You can claim up to $2,000 in tax relief per return but if the LLC reduces your annual tax liability to zero, you won’t get a refund on the remaining credit. You will find details pertaining to LLC eligibility at IRS Website
You can only use one of these tax credits per year per student. So, if in a household, there are two dependent students, and if AOTC is claimed for one, you can’t claim it for the other student. However, you can claim the LLC for the second student.
These tax credits can be claimed even if you have used student debt to finance your education costs. Furthermore, either of these credits can be claimed along with the student loan interest deduction.
How does marriage influence taxes on student loan interests?
Everything discussed above applies to people who are filing their taxes under the status, widow(er), head of household or single. Once you are married, the IRS actively encourages you to file your taxes jointly. So, your standard deductions are higher as is your income threshold for specific deductions and taxes, and you are eligible for certain tax breaks
As far as student loan deductions are concerned, if you are filing jointly, you get to claim the $2500 annually as long as your joint taxable income isn’t above $140,000. However, you only get to claim a maximum of $2,500 even if both spouses are paying student loans.
If you are married but file separately, you are not eligible for student loan interest deductions nor for the two tax credits discussed above. So, why would anybody want to give up on the tax breaks and file separately?
Simple, it helps to keep the monthly federal loan repayment low if the borrower has taken out a student loan on an income-based repayment plan. Yet, experts recommend that filing separately should exclusively be considered if that is the only option to keep up with the monthly payments.
Will you continue to be eligible for student loan tax deduction even if you refinance your student debt?
As with other forms of debt, refinancing is the best way to consolidate the loans into a single monthly payment and possibly get lower interest rates in the process. If you do choose to refinance, any deductions will be based on your new interest rates.
However, there is a catch. The interest on the refinanced loan will only qualify for the deduction if the entire amount borrowed is used exclusively for qualified educational purposes.
If you refinance the loan for more than your original student debt and if the additional money is not used/wasn’t used to pay for qualified education expenses, the interest on the entire amount loses the eligibility for the deduction.
Student debt relief and taxes
If your student loan has become unmanageable, debt forgiveness and/or cancellation may be a “godsend” for you. Similarly, if you have diligently repaid your student loan installments for 25 years, loan discharge may give you some much needed and well-earned reprieve. For those who have taken out a private loan, debt settlement may be the only option to deal with loan repayment issues.
While all these terms have different meanings, in essence, they all either reduce or eliminate your debt burden. Normally, this would be good news except that the tax implications of loan forgiveness, discharge or debt settlement can sink the boat.
Now, this is murky territory because while some forms of loan relief are taxed others are not. So, before you consider this option, take a look at what awaits you in the future if you do have your loan canceled.
Taxes on Federal Student Loan Forgiveness
Typically, when talking about federal student loan forgiveness, people are referring to one of the following programs:
- Public service loan forgiveness (PSLF)
- Teacher loan forgiveness
- National Health Service Corps Loan Repayment Program
- Law school loan repayment assistance programs
All four of these are tax-free. Furthermore, several state loan forgiveness and repayment programs offered to health professionals are also tax-free if the programs are aimed at increasing the availability of health care professionals in underserved areas.
Tax implications of student loan discharge and cancellation
Generally, any relief received from student loan discharge and cancellation programs is considered taxable income. This includes cancellations due to:
- Closed school
- Unpaid loan refund
- False loan certification
However, if you have taken out a federal student loan, including Federal Perkins Loan, Federal Family Education Loan or Federal Direct Loan, the Department of Education can discharge the debt if:
- The school closed down while the student was attending.
- The borrower establishes that the actions of the school give rise, under applicable state laws, to a cause of action against the institution.
Such a discharge is tax-free, but notice that it only applies to federal loans and not to private loans. In addition to these, since 2018, Trump Administration has made discharge of loans due to death and disability, tax-free.
What about student loan repayment plans with forgiveness?
Federal loan repayment plans such as PAYE and IBR do qualify for balance forgiveness after a certain amount of time, usually after 20 to 25 years of consistent payments. These programs are taxable and you will have to pay taxes on the entire amount that has been forgiven.
Are repayment assistance programs also taxable?
In the case of these programs, taxability differs from state to state. So, you will have to check with the program itself. Make sure that you understand both the federal and the state tax impact of the program. Many states do not charge taxes on repayment assistance programs but federal taxes do apply to such programs.
Is student loan assistance in the private sector taxed?
Yes, any form or extent of loan assistance in the private sector, excluding PSLF, is considered taxable income. The amount canceled will be taxed based on your new tax bracket that results by adding the taxable income earned by you and the amount of loan forgiven.
Are there taxes on student loan forgiveness due to disability?
If you have taken out a federal student loan and cannot work due to an injury or illness, you may qualify for discharge of the loan due to permanent and total disability. Such a discharge would not be taxed. To qualify for this tax-free discharge, you will have to prove your disability with either:
- A doctor’s certificate
- A certificate from the Department of Veterans Affairs.
- Social security benefits.
Do borrowers have to pay taxes on student loan discharge due to financial hardship?
If your student loan has been discharged due to insolvency or bankruptcy, you will qualify for the tax exclusion that makes the debt relief tax free. To be considered insolvent, your liabilities, including your loans, have to exceed the total value of all your assets.
Similarly, if your student debt is discharged in bankruptcy proceedings, this form of loan relief also falls in the non-taxable category. However, even if the bankruptcy or insolvency exclusion applies to your loan discharge, the entire amount may not qualify for this exclusion
Student Loans Tax Refund Garnishment
Nobody is automatically going to take away your student loan tax refund just because you have outstanding student debt. However, you can lose the refund and even your wages if you have defaulted on your loan payments.
When you borrow money from a private company, they have to get a court order to garnish your wages and any money in your bank account, including that which has come to you courtesy of student loan tax refund.
But, if you have borrowed from the government, they don’t need to go to court to initiate this action against you. So, the thing to note here is that a tax offset is only possible if you default on federal student loans.
The federal government has ways to collect their money!
If you default on your federal student loan, there are 4 options that the government has for collecting their dues:
- Tax refund offset: They can withhold the entire federal income tax refund, including the refund on student loan interest, up to the amount of money owed.
- Wage garnishment: They can take 15% of your salary until your payments are made current.
- Federal salary intercept: Federal employees can have 15% of their earnings withheld to pay off the defaulted loan.
- Social security benefits offset: They can divert a portion of your social security benefits towards your loan payments.
How much time before they start garnishing wages and tax refunds?
In terms of time, there are only 30 days between your being current with your loans and being in default. Your loan becomes delinquent if you don’t pay within 30 days of your repayment due date. Thereafter, for monthly payments the loan goes into default after 9 months or 270 days and for bi-monthly payments, it goes into default after 11 months or 330 days.
If you allow the loan to go into default, the government will initiate the garnishment procedure. You will receive a notice of offset or garnishment 30 days prior to the actual deduction of the money from your account. If you do not settle things with the lender within these 30 days, they will garnish your tax refunds and wages.
Are you facing a student loan tax offset?
As explained above, you will receive an offset notice 30 days prior to the actual intercept of your tax refund. This is done to give you some time to respond. However, they are under no obligation to make sure that the notice gets to you.
For instance, if they have the wrong address on file, the notice may never reach you. Unfortunately, you do not get a legal recourse to challenge the garnishment on the ground that you never received the offset notification from the IRS.
So, if you have defaulted on your federal student loan and haven’t received a notice of garnishment, you may want to contact:
- The Treasury Offset Program at 1-800-304-3107
- The Internal Revenue Service at 1-877-777-4778 (Only if the refund was offset in error)
- The Financial Management Service at 1-800-304-3107 (Only to know if you received a lower refund due to offset)
How to stop student loan tax garnishment?
You can challenge the offset before it begins. However, this can only be done if you think that the offset is initiated in error. It goes without saying that you will need documents to prove such errors.
In any case, when you receive the notice of offset, make sure that you cross-check all the information in the notice against your loan accounts statement. If there are any errors, you will have ground to challenge the offset. Generally, you can request a review hearing if:
- You have not taken the student loan.
- You have received a TPD discharge of your student loan.
- The document shows an incorrect loan balance.
- The debt discharge/forgiveness program is not taxable.
- You haven’t defaulted on your loan.
- Your loans have been discharged in bankruptcy proceedings.
- You are following a debt rehabilitation program.
Avoiding tax offset by the rehabilitation of your student loan
You can steer clear of a tax offset by agreeing to a payment plan to get your loan back in good standing. This is known as loan rehabilitation and this is how it works:
- You and the federal loan servicer will agree on a payment plan that is reasonable and that you can afford.
- You start making payments as per this new plan to bring your loan to current. Typically, loan rehabilitation runs its course over 9 months.
- If you fall back on your payments again during this time, the recovery period restarts.
- Once the rehabilitation has been completed and your loan is back in good standing, you go back to making your pre-rehab, larger payments.
If it is getting increasingly difficult to make your monthly loan payments, you should consider an IDR Federal Income-Driven Repayment Plans.
Loan consolidation to prevent tax refund offset
Those of you, who have borrowed from the federal government, get to avail the in-built benefit of Direct Loan Consolidation. However, this has to be done well in advance of the offset process initiation.
Consolidating your federal student loans in time can help you to avoid a tax offset because as soon as you pay off an existing loan through consolidation, you are no longer in default. Like loan rehabilitation, consolidation is another way to seek an IDR plan that will make your monthly loan payment more manageable.
Can the IRS take your spouse’s tax refund if you are in default?
If the taxes are filed jointly, yes, the IRS can offset the tax refund of one spouse to make up for the loan default of the other spouse. Fortunately, there is a simple procedure to circumvent this type of offset. Filing an Injured Spouse Claim may allow you to get your refund back.
If you are subjected to a tax refund offset because of your spouse’s debt, you will be considered the Injured Spouse’. This means you can file a claim that allows you to get a part of your tax refund back. To file the Injured Spouse Claim, you should have:
- Paid federal income tax.
- Claimed a tax credit that is refundable.
- Filed your returns jointly with your spouse.
Also, you should not be responsible in any way/sense for the debt or its repayment that led to the offset in the first place. Use IRS Form 8379 to file the Injured Spouse Claim. You can find more information on this at injured or innocent spouse tax relief.
Is there any other way to get your student loan tax refund after the offset?
Although the chances are slim, it is possible to get your refund if you can prove financial hardship. The bad news is that the inability to pay your bills is not considered as proof of financial distress. Some of the reasons that would qualify as financial hardships include:
- Losing your home to eviction or foreclosure.
- Disconnection or shutoff of utility services.
- Running out of unemployment benefits.
Needless to say, you will have to provide documentation to prove the above claims. Get in touch with your federal student loan holder to access their tax offset hardship request form.
Getting help from a student loan adviser:
Defaulting on your student loans, whether federal or private, can have serious and longstanding ramifications. Along the same lines, seeking and accepting any form of loan relief without clearly understanding the tax implications of it can turn into a nightmare scenario.
Getting help from a student loan adviser is advisable for a number of reasons. Services that a student loan consultant can provide include:
- student loan tax-related issues before they turn into a problem that impacts your professional and personal life for years to come
- Developing a repayment strategy that is suited to your financial situation
- Explain student loan jargon in a way that is understandable
- Help you modify repayment plans if your life plans change
- Do research for you and talk to lenders to save you time
A variety of options are available for student loan relief and it is possible to get tax-free loan forgiveness, discharge and settlement. Unfortunately, the process is often complicated and the paperwork overwhelming
To add to the issue, once you default on your student loans, you will be hounded by collection calls. So, don’t live under the constant fear of student loan tax and wage garnishment.
If there is even the remotest possibility that you may fall behind on your student loan payments, you need to act at once. The last thing you want to do is to wait and watch and let the situation get out of hands. Above all, why go through the hassle, when student loan advisors are there to help?