Tax season is a great time to do a student loan checkup. Most student loan borrowers realize that there is a deduction for student loan interest. However, there are other student loan elements to consider at tax time. For example, a smart tax strategy can result in lower student loan payments for the following year.
This article will cover everything from the student loan interest deduction to advanced strategies for lowering payments and tax bills and increasing retirement accounts.
The Student Loan Interest Deduction on 2021 Tax Returns
Student loan borrowers can claim a deduction of up to $2,500 on their 2021 tax returns. The IRS bases this deduction on the amount spent on student loan interest payments. This deduction applies to both private and federal student loans. However, money spent paying down the principal balance isn’t counted towards this deduction. Your lender should send a 1098-E tax document with an exact accounting of the money spent on student loan interest.
Note: Lenders are only required to supply a 1098-E for borrowers who pay over $600 in interest. If you spent less or have small loans with various lenders, you can still deduct that amount. Just be aware that you might have to contact your lender for documentation.
For further information, including income limits and phase out, be sure to jump down to the student loan interest deduction FAQ.
If you have concerns about whether or not your student loan interest is an eligible deduction, the IRS has a comprehensive tool for determining if you qualify.
Timing Income Certifications During 2022
Student loan borrowers on income-driven repayment plans must certify their income every year. Most borrowers certify by supplying the Department of Education with their most recent tax return.
Those who are about to start an income-driven repayment plan may want to consider the timing of their application. Those who earned less in 2020 than in 2021 would benefit from applying for income-driven repayment before filing 2021 tax returns. This way, the income-driven repayment plan application will result in lower monthly payments.
Borrowers already enrolled should investigate and make a mental note of when they next need to certify their income. Missing the income certification deadlines can be expensive, so tax time is a great time to verify that everything is in order.
Student Loan Checkup
Filing taxes requires many student loan borrowers to spend a little time on the websites of their various lenders. During this time, a quick checkup can be a great way to catch any potential issues.
Borrowers should review the following:
Loan Balances – When checking loan balances, it is beneficial to review recent payments. Check to see how much went to interest versus the principal. Borrowers who have the bulk of their payments going towards interest should consider paying extra to accelerate repayment or investigate ways to get a lower interest rate.
Automatic Payment Settings – Automatic payments can be a hassle, but they often qualify for a .25% interest rate reduction. The rate reduction isn’t huge, but it is something. Make sure you have the correct amount withdrawn. Also, verify that it is coming out of the correct bank account.
Look for Late Fees – Lenders are experts at adding fees whenever possible. Check recent payments to make sure your lenders didn’t charge any fees. If they did, call to dispute the fees and/or find ways to avoid future charges.
Check Interest Rates – Many student loans have variable interest rates. Because interest rates are currently rising, it’s essential to check on the potential movement of your student loan interest rates. If your interest rate has jumped, consider switching to a fixed-rate loan with a student loan refinance company like Splash or ELFI.
Educational Tax Credits
The American Opportunity Credit offers up to $2,500 in partially refundable credits. The Lifetime Learning Credit provides up to $2,000 in nonrefundable credits. However, only those enrolled in an eligible educational institution can qualify for these credits. The educational institution should send out a 1098-T to aid in figuring out your credit.
The IRS has a detailed breakdown comparing these credits. The IRS also has a very useful Q and A explaining the educational tax credits. Current students and their parents will want to pay close attention.
Take Advantage of Retirement Contributions
The more money you put into your traditional IRA or 401(k), the less you’ll be required to pay if you’re on a federal income-driven repayment plan such as IBR, PAYE, REPAY, or ICR.
The IRS provides some flexibility about which tax year your contributions can be applied towards the income tax deduction. In other words, you can use IRA contributions made 1/1/2022 through 4/15/2022 towards the 2021 tax year or the 2022 tax year. Make sure you don’t make the mistake of trying to count the payment towards both years.
Traditional IRAs and 401(k)s are not the only accounts you can use to lower student loan payments. For example, many retirement plans for government employees, like 457 plans, also count. Those who have HSAs (Health Savings Accounts) can also make contributions that will lower their required student loan payment.
This tactic of shielding income from counting towards student loan payments can be especially useful for borrowers working towards federal student loan forgiveness programs.
By making this move, student loan borrowers can:
- Lower their tax bill,
- Save extra money for retirement,
- Lower their student loan bill for the next year, and
- Increase the amount of student debt that is forgiven.
Saving for retirement may not seem like much of a priority when you are facing a mountain of student debt, but the sooner you start saving for retirement, the better. Plus, this strategy is a good way to accomplish multiple goals with one move.
Tax Time is Employer Certification Form Time
Employment certification forms are essential in tracking progress towards Public Service Loan Forgiveness (PSLF).
There isn’t a requirement to submit your employer certification form at tax time, but it is an excellent habit to get started. Yearly submission of these forms is the best way to ensure that you are meeting the requirements for PSLF. By making employer certification forms part of your annual tax routine, you ensure that this critical step doesn’t get skipped over.
Due to confusion regarding employer certifications and PSLF in general, the Department of Education created the PSLF Help Tool. Borrowers can use this tool to determine employer eligibility and generate the proper form to certify employment.
Should Student Loan Borrowers File 2021 Tax Returns Jointly or Married Filing Separately?
The biggest and most challenging question for married couples with student loans at tax time is whether or not to file as a couple.
The crux of the issue boils down to a simple problem:
- File separately, and income-driven repayment calculations are based upon one income rather than two, BUT
- Filing separately results in a larger tax bill.
This calculation can be quite tricky, especially when you factor in all the other strategies at play during tax time.
We do have several tips that can help couples facing this dilemma.
- Calculate taxes both ways – The only thing more miserable than doing taxes once is doing them multiple times. However, the only way to find out the cost of filing separately is to do the math for both routes. If you have an accountant or tax prep service, they should be able to tell you the difference in cost.
- Estimate the monthly student loan savings – The Department of Education has a very useful Student Loan Repayment Simulator. The total spending figures that it generates leave a little to be desired, but the monthly payment estimation is quite good. This will help calculate the benefit of filing separately.
- The math is easy for couples who both have federal loans – Generally speaking, couples who both have federal student loans and are both on an income-driven repayment plan will be better off filing jointly. Many fear that by filing as a couple, their payments will double, but that is not the case.
- Remember the student loan interest deduction – Couples that file as married filing separately are not eligible for the student loan interest deduction. The value of this deduction can be pretty small due to its many limitations, but it might be enough to change the math.
Borrowers should also keep in mind that while lower payments on their student loans are desirable, the goal is to eliminate the debt. Even if you get lower IBR payments for the next year, it just means more spending on interest before the loan is paid off. The math changes for those pursuing forgiveness. But, it doesn’t make sense for many borrowers to pay extra in taxes to prolong paying off student loans.
If you want to get creative with your taxes for student loan purposes, we think most couples would benefit more in the long-run by filing jointly and lowering their income via retirement contributions rather than filing separately.
Student Loan Interest Deduction FAQ
For the tax year 2021 (aka the taxes filed in 2022), the maximum deduction is $2,500.
No. This is a very common misconception. When tax people use the term “deduction,” they are talking about “deducting” it from your income, not from what you owe.
If you paid over $2500 in student loan interest on a salary of $52,500, your salary in the eyes of the IRS would be lowered to $50,000.
In short, the deduction means that you are taxed on less of the money you earn.
Because of the income limits with this particular deduction, the most an individual can save on their taxes is $550. This number is based upon a tax rate of 22%. While some people do fall in higher tax brackets, their income is too high to qualify for the deduction.
To qualify for the entire deduction on their 2020 taxes, individual income must be less than $70,000 (or $140,000 for married couples). At that point, the student loan interest deduction begins to phase out, meaning people who make above $70,000 can only claim a portion of the deduction. Individuals making over $85,000 (or couples making over $170,000) per year cannot claim the deduction at all.
Couples that file their taxes as married filing separately cannot claim the student loan interest deduction. Anyone who is claimed as a dependant is also ineligible for the student loan interest deduction.
Note: These numbers are adjusted each year. For those planning their 2022 taxes, the limits could be even higher.
Yes. The student loan interest deduction is known as an “above the line” deduction. That means that all taxpayers can take the deduction, not just those who itemize.
Generally speaking, taxpayers have the option of taking the standard deduction or itemizing all of their deductions. The exceptions to this general rule are called above-the-line deductions. Student loan interest falls within this exception. Taxpayers can take the standard deduction and the student loan interest deduction.
The important detail is the interest. Suppose you are in your 6-month grace period after graduation or on a forbearance. Payments that you make during this time could potentially be applied to your principal balance or towards interest. Payments applied towards interest, even if the payment wasn’t required, can be deducted.
The student loan interest deduction helps out some borrowers at tax time, but due to the many limitations that we have already described, borrowers can still take a beating on interest.
Letting student loans linger just for a tax break would be like paying a dollar to get a quarter. Getting a quarter is good, but not if the cost is a dollar.
In most cases, the student loan interest deduction is not enough to alter student loan repayment strategy.
For more detailed information on the student loan interest deduction and how it works, check out the IRS page on student interest. The IRS also has a handy tool for determining if your payments were eligible.
One Final Tax Tip for Student Loan Borrowers Filing Their 2021 Tax Return
The idea of spending extra time messing with your finances during tax time may not seem appealing. Just getting taxes filed is already a pain.
However, putting in a little extra effort to take advantage of opportunities for student loan borrowers can save a bunch of money and save the time of having to do things twice.