How Student Debt Affects Your Taxes
Americans owe over $1.3 trillion in student debt, a number that continues to increase as the cost of education rises. Nearly 40% of adults under 30 have student loan debt with two-thirds of college seniors taking out a loan to pay for their education, according to the Pew Research Center. While the median amount of debt among all borrowers is $17,000, one-quarter of student loan borrowers owe at least $43,000.
The cost of student debt often makes headlines, but the impact of student debt on taxes is often overlooked. Student loan debt can impact taxes in many ways, both positive and negative.
Student Debt and Tax Deductions
Student loans are expensive and can be difficult to manage but there may be tax benefits that help offset the cost. Student loan borrowers can deduct the student loan interest paid every year through the student loan interest deduction. This reduces the borrower’s taxable income by up to $2,500 for borrowers whose modified adjusted gross income is less than $65,000 or by a lesser amount for higher income levels. There is an IRS tool borrowers can use to check if they are eligible to claim the deduction.
This deduction can result in $625 back for borrowers in the 25% tax bracket. It’s important to remember that only the borrower who took out the loan can get the deduction, whether it’s the student or the parent, but neither qualifies for the deduction if the student is listed as a dependent on the parent’s return.
This is the only tax deduction applicable to student loans but there are tax credits available for students in college such as the American Opportunity Credit which is worth up to $2,500 per year for students attending at least half-time. The Lifetime Learning Credit is another credit worth up to $2,000 per year for books, supplies, fees, and tuition. These credits are only available to students still in school.
Student Loan Tax Refund Offset
When a federal student loan falls into default, the Department of Education can refer the account for collection to the Department of Treasury. This is done through a tax refund offset of the borrower’s federal and sometimes even state return. The Treasury can withhold the entire refund amount and apply it toward the outstanding student debt.
Under the law, the IRS must provide a proposed offset and the chance to review loan records. This notice is sent by mail. It is possible to prevent or overturn a student offset, however. Possible solutions may include:
- Consolidating the loan. Borrowers who are eligible for consolidation can bundle all student loans into a single loan, usually with a new federal lender. Once consolidation is complete, the student loan is no longer in default and there is no longer a risk of an offset. Borrowers may also be able to qualify for payment plans during consolidation such as the Income-Based Repayment Plan (IBR).
- Rehabilitating the loan. It may be possible to reach an agreement with the lender to make the payment plan affordable and bring the loan current. Loan rehabilitation usually takes 9 months with on-time payments.
- Repay the defaulted loan in full.
For most people, a tax refund offset can be a significant financial burden. Even after a refund has been offset, it may be possible to get it back with a student loan tax offset hardship refund request. There are many circumstances under which students can qualify for a hardship refund of an offset such as:
- Proof of eviction or foreclosure
- Utility disconnection notice
- Proof of exhausted unemployment benefits
- Filed for bankruptcy
- Totally and permanently disabled
Student Loan Forgiveness and Tax Consequences
Federal student loans come with a benefit not available with private loans: the option for student loan forgiveness. Under some circumstances, federal student loan borrowers may have their outstanding balance forgiven. This option is only available under certain circumstances, however. There are multiple student loan forgiveness programs available such as:
- Teacher loan forgiveness. This program is available for borrowers who meet specific teaching requirements.
- Public service loan forgiveness. This program is available for borrowers who get a job at a nonprofit or government organization, repay the loan based on their income, and maintain their employment for 10 years.
- Student loan forgiveness for nurses through state and federal programs such as the NURSE Corps program.
- Income-Based Repayment (IBR) forgiveness. The IBR plan caps payments at 10-15% of the borrower’s discretionary income but the balance is forgiven after 20-25 years of consistent payments.
While loan forgiveness may make sense, there may be tax consequences. The amount of student debt that is forgiven can be transformed into tax debt, a substantial hidden cost to a seemingly clear-cut decision.
This tax debt usually comes into play with the Income-Driven Repayment plan, which comes with forgiveness of the remaining balance after 20 to 25 years of repayment. Under current IRS rules, any loans forgiven under this program is considered taxable income. If $40,000 is forgiven, for example, the borrower may be left with a $10,000 or more tax bill along with state income taxes. This can force the borrower into a new payment plan with the IRS to pay down the tax debt.
What Can Borrowers Do About Student Debt?
According to the Federal Reserve, the average student loan payment is $393 although some borrowers pay much more. Student loan debt can be a substantial burden and make it difficult to qualify for a mortgage or even pay for daily living expenses. Borrowers have many options for combating the financial burden of student debt.
A financial advisor specializing in student loan debt is one solution to help borrowers better understand their situation and assess their options, including student loan forgiveness, loan consolidation, and repayment plans. Along with repayment plans like an Income-Based Repayment plan, there are strategies that can help pay off student loans faster such as making extra loan payments or paying more than the minimum payment. Refinancing can also be a good strategy to reduce the loan’s interest rate. A refinance pays off the existing loan and replaces it with a new loan at a lower interest rate. It’s even possible to refinance a federal loan into a private loan, although it’s still a good idea to consult with a financial advisor as there may be consequences to this decision such as the loss of repayment plan and forbearance options.